Contents Publication 541 Cat. No. 15071D Introduction ...... 1

Department Forming a Partnership ...... 2 of the Treasury Partnerships Terminating a Partnership ...... 3 Internal Exclusion From Partnership Rules .. 3 Revenue Service For use in preparing Tax Year ...... 4 Partnership Return (Form 1065) ...... 5 1997 Returns Penalties ...... 5

Partnership Income or Loss ...... 5

Partner's Distributive Share ...... 6

Partnership Distributions ...... 8

Transactions Between Partnership and Partners ...... 11

Basis of Partner's Interest ...... 13

Disposition of Partner's Interest ...... 15

Adjusting the Basis of Partnership Property ...... 18

Form 1065 Example ...... 18

How To Get More Information ...... 27

Index ...... 27

Introduction This publication explains how the tax law ap- plies to partnerships and to partners. A part- nership does not pay tax on its income but “passes through” any profits or losses to its partners. Partners must include partnership items on their tax returns. For a discussion of business expenses a partnership can deduct, see Publication 535. Members of oil and gas partnerships should read about the deduction for depletion in chapter 13 of that publication. Certain partnerships must have a tax matters partner (TMP) who is also a general partner. For information on the rules for des- ignating a TMP, see the instructions for Schedule B of Form 1065 and Temporary Regulations section 301.6231(a)(7)–1T.

Withholding on foreign partner or firm. If a partnership acquires a U.S. real property interest from a foreign person or firm, the partnership may have to withhold tax on the amount it pays for the property (including cash, fair market value of other property, and any assumed liability). If a partnership has Get forms and other information faster and easier by: income effectively connected with a trade or COMPUTER business in the United States, it must with- • World Wide Web ➤ www.irs.ustreas.gov hold on the income allocable to its foreign ➤ partners. A partnership may have to withhold • FTP ftp.irs.ustreas.gov tax on a foreign partner's distributive share • IRIS at FedWorld ➤ (703) 321-8020 of fixed or determinable income not effectively FAX connected with a U.S. trade or business. A ➤ partnership that fails to withhold may be held • From your FAX machine, dial (703) 368-9694 liable for the tax, applicable penalties, and See How To Get More Information in this publication. interest. For more information, see Publica- tion 515, Withholding of Tax on Nonresident Aliens and Foreign Corporations. cess to TTY/TDD equipment, you can call is carrying on a trade or business and is not 1–800–829–4059 to obtain this assistance. classified as a trust, estate, or corporation. Important Changes for Although the PRP office cannot change A joint undertaking merely to share ex- the tax law or a technical tax decision, it can penses is not a partnership. Mere co- 1997 clear up problems that resulted from previous ownership of property maintained and leased contacts and ensure your case is given a or rented is not a partnership. However, if the Businesses classified as partnerships. complete and impartial review. For more in- co-owners provide services to the tenants, a The rules you must use to determine whether formation, see Publication 1546, The Problem partnership exists. a business is classified as a partnership Resolution Program of the Internal Revenue changed for businesses formed after 1996. Service. Organizations formed after 1996. An For more information, see Forming a Part- unincorporated organization (including a lim- nership. Comments on IRS enforcement actions. ited liability company) formed after 1996 is The Small Business and Agricultural Regula- classified as a partnership if it: Recognition period for precontribution tory Enforcement Ombudsman and 10 Re- gain. For appreciated property contributed gional Fairness Boards were established to 1) Has not made an election to be classified to a partnership after June 8, 1997, the period receive comments from small business about as a corporation, in which a contributing partner must recognize federal agency enforcement actions. The precontribution gain is extended from 5 years Ombudsman will annually evaluate the 2) Has more than one member, to 7 years. For more information, see Part- enforcement activities and rate each agency's 3) Is organized to carry on business, ner's Gain or Loss under Partnership Distri- responsiveness to small business. If you wish butions. to comment on the enforcement actions of the 4) Is formed in the United States, IRS, call 1–888–734–3247. 5) Is not organized under a law that de- Allocated basis of distributed properties. scribes it as a corporation, body corpo- For a distribution of partnership properties Useful Items rate, body politic, joint-stock company, after August 5, 1997, the method of allocating You may want to see: or joint-stock association, and a partner's basis in the partnership among the properties received has been changed. For 6) Is not an insurance company, real estate Publication more information, see Partner's Basis for investment trust, exempt organization, or a bank whose deposits are insured Distributed Property under Partnership Distri- Ⅺ 505 Tax Withholding and Estimated under the Federal Deposit Insurance Act butions. Tax or similar statute. Sale of partnership interest. For a sale or Ⅺ 533 Self-Employment Tax Many organizations that would meet these exchange of a partnership interest after Au- Ⅺ 535 Business Expenses criteria except that they were formed outside gust 5, 1997, it is no longer necessary that the United States are also classified as part- inventory be substantially appreciated before Ⅺ 537 Installment Sales nerships. See section 301.7701–2 of the it generates ordinary income (rather than Ⅺ 538 Accounting Periods and Methods Procedure and Administration Regulations for capital gain). Under the new rule, the amount details. attributable to both inventory and unrealized Ⅺ 544 Sales and Other Dispositions of An organization that would meet these receivables is treated as realized from the Assets criteria except that it has only one member is sale or exchange of property that is not a Ⅺ 551 Basis of Assets disregarded for federal tax purposes. Instead, capital asset. For more information, see Pay- all income, deductions, credits, and losses ments for Unrealized Receivables and Inven- Ⅺ 925 Passive Activity and At-Risk Rules from the organization are reported on the tory Items under Disposition of Partner's In- Ⅺ 946 How To Depreciate Property owner's return. terest. Form (and Instructions) Organizations formed before 1997. An or- ganization that was formed before 1997 gen- Ⅺ 1065 U.S. Partnership Return of In- erally keeps the classification it had previ- Important Change for come ously, unless it elects to change its Ⅺ Schedule K–1 (Form 1065) Partner's classification. However, an organization can- 1998 Share of Income, Credits, De- not keep its classification as a partnership if ductions, Etc. it has only one member. To be treated as Closing of partnership's tax year with re- separate from its owner, it must elect to be spect to deceased partner. For partnership Ⅺ 8308 Report of a Sale or Exchange of classified as a corporation. tax years beginning after 1997, the partner- Certain Partnership Interests ship's tax year closes with respect to a part- Ⅺ 8582 Passive Activity Loss Limitations Changing an organization's classification. ner whose entire interest in the partnership is An organization that is classified as a part- terminated, whether by death, sale or ex- Ⅺ 8736 Application for Automatic Exten- nership (or that would be classified as a change, or liquidation. Previously, the part- sion of Time To File U.S. Return partnership except that it has only one mem- nership's tax year closed only with respect to for a Partnership, REMIC, or for ber) generally can elect to be classified as a a partner who sold, exchanged, or liquidated Certain Trusts corporation. An organization previously clas- his or her entire interest in the partnership. Ⅺ 8832 Entity Classification Election sified as a corporation but that can be classi- For more information, see Distributive Share fied as a partnership can elect to change its See How To Get More Information near in Year of Disposition under Disposition of classification to a partnership. To make the the end of this publication for information Partner's Interest. election, the organization must file Form about getting these publications and forms. 8832, Entity Classification Election.

Conversion of partnership into limited li- Important Reminders ability company (LLC). The conversion of Forming a Partnership a partnership into an LLC classified as a Unresolved tax problems. The Problem A partnership is the relationship between two partnership for federal tax purposes does not Resolution Program (PRP), which is ad- or more persons who join together to carry terminate the partnership. The conversion is ministered by the Taxpayer Advocate, is for on a trade or business. Each person contrib- not a sale, exchange, or liquidation of any taxpayers who have been unable to resolve utes money, property, labor, or skill, and each partnership interest, the partnership's tax year their problems with the IRS. If you have a tax expects to share in the profits and losses. does not close, and the LLC can continue to problem you cannot clear up through normal “Person,” when used to describe a partner, use the partnership's taxpayer identification channels, you can call the IRS at means an individual, a corporation, a trust, number. 1–800–829–1040 for PRP assistance. If you an estate, or another partnership. However, the conversion may change prefer, you can write to the office that last For federal income tax purposes, the term some of the partners' bases in their partner- contacted you (or your local district director) “partnership” includes a syndicate, group, ship interests if the partnership has recourse and ask for PRP assistance. If you have ac- pool, joint venture, or similar organization that liabilities that become nonrecourse liabilities. Page 2 Because the partners share recourse and Purchase. For purposes of determining changed within a 12-month period, in- nonrecourse liabilities differently, their bases a partner's distributive share, an interest pur- cluding a sale or exchange to another must be adjusted to reflect the new sharing chased by one family member from another partner. ratios. If a decrease in a partner's share of family member is considered a gift from the liabilities exceeds the partner's basis, he or seller. The fair market value of the purchased See Regulations section 1.708–1(b)(1) for she must recognize gain on the excess. For interest is considered donated capital. For this more information on the termination of a more information, see Effect of Partnership purpose, members of a family include only partnership. For special rules that apply to a Liabilities under Basis of Partner's Interest, spouses, ancestors, and lineal descendants merger, consolidation, or division of a part- later. (or a trust for the primary benefit of those nership, see Regulations section The same rules apply if an LLC classified persons). 1.708–1(b)(2). as a partnership is converted into a partner- ship. Example. A father sold 50% of his busi- Date of termination. The partnership's tax ness to his son. The resulting partnership had year ends on the date of termination. For a profit of $60,000. Capital is a material purposes of (1) above, the date of termination Family Partnership income-producing factor. The father per- is the date the partnership completes the Members of a family can be partners. How- formed services worth $24,000, which is rea- winding up of its affairs. For purposes of (2) ever, family members (or any other person) sonable compensation, and the son per- above, the date of termination is the date of will be recognized as partners only if one of formed no services. The $24,000 must be the sale or exchange of a partnership interest the following requirements is met. allocated to the father as compensation. Of that, by itself or together with other sales or the remaining $36,000 of profit due to capital, exchanges in the preceding 12 months, 1) If capital is a material income-producing at least 50%, or $18,000, must be allocated transfers an interest of 50% or more in both factor, they acquired their capital interest to the father since he owns a 50% capital in- capital and profits. in a bona fide transaction (even if by gift terest. The son's share of partnership profit or purchase from another family mem- cannot be more than $18,000. Short period return. If a partnership is ter- ber), actually own the partnership inter- minated before the end of the tax year, Form est, and actually control the interest. Husband-wife partnership. If spouses carry 1065 must be filed for the short period, which on a business together and share in the pro- is the period from the beginning of the tax 2) If capital is not a material income- fits and losses, they may be partners whether year through the date of termination. The re- producing factor, they must have joined or not they have a formal partnership agree- turn is due the 15th day of the fourth month together in good faith to conduct a busi- ment. If so, they should report income or loss following the date of termination. See Part- ness. In addition, they must have agreed from the business on Form 1065. They should nership Return (Form 1065), later, for infor- that contributions of each entitle them to not report the income on a Schedule C (Form mation about filing Form 1065. a share in the profits. Some capital or 1040) in the name of one spouse as a sole service must be provided by each part- proprietor. ner. Each spouse should carry his or her share of the partnership income or loss from Exclusion From Capital is material. Capital is a material Schedule K–1 (Form 1065) to their joint or income-producing factor if a substantial part separate Form(s) 1040. Each spouse should Partnership Rules of the gross income of the business comes include his or her respective share of self- from the use of capital. Capital is ordinarily employment income on a separate Schedule Certain partnerships that do not actively con- an income-producing factor if the operation SE (Form 1040), Self-Employment Tax. This duct a business can choose to be completely of the business requires substantial invento- generally does not increase the total tax on or partially excluded from being treated as ries or investments in plants, machinery, or the return, but it does give each spouse credit partnerships for federal income tax purposes equipment. for social security earnings on which retire- if all the partners agree and the partners can ment benefits are based. compute their own taxable income without computing the partnership's taxable income. Capital is not material. In general, capital However, the partners are not exempt from is not a material income-producing factor if the rule that limits a partner's distributive the income of the business consists princi- Partnership Agreement share of partnership loss. Nor are they ex- pally of fees, commissions, or other compen- The partnership agreement includes the ori- empt from the requirement of a business sation for personal services performed by ginal agreement and any modifications. The purpose for adopting a tax year for the part- members or employees of the partnership. modifications must be agreed to by all part- nership that differs from its required tax year, ners or adopted in any other manner provided discussed later. Capital interest. A capital interest in a part- by the partnership agreement. The agree- ment or modifications can be oral or written. nership is an interest in its assets that is dis- Investing partnership. An investing part- Partners can modify the partnership tributable to the owner of the interest if: nership can be excluded if the participants in agreement for a particular tax year after the the joint purchase, retention, sale, or ex- close of the year but not later than the date 1) He or she withdraws from the partner- change of investment property: ship, or for filing the partnership return for that year. This filing date does not include any exten- 1) Own the property as co-owners, 2) The partnership liquidates. sion of time. If the partnership agreement or any mod- 2) Reserve the right separately to take or The mere right to share in earnings and ification is silent on any matter, the provisions dispose of their shares of any property profits is not a capital interest in the partner- of local law are treated as part of the agree- acquired or retained, and ship. ment. 3) Do not actively conduct business or Gift of capital interest. If a family member irrevocably authorize some person act- (or any other person) receives a gift of a ing in a representative capacity to pur- capital interest in a partnership in which cap- chase, sell, or exchange the investment ital is a material income-producing factor, the Terminating a property. Each separate participant can donee's distributive share of partnership in- delegate authority to purchase, sell, or come is limited. To figure the donee's share: Partnership exchange his or her share of the invest- A partnership terminates when: ment property for the time being for his 1) The partnership income must be re- or her account, but not for a period of duced by reasonable compensation for 1) All of its operations are discontinued and more than a year. services the donor renders to the part- no part of any business, financial opera- nership, and tion, or venture is continued by any of its Operating agreement partnership. An op- partners in a partnership or a limited li- erating agreement partnership group can be 2) The donee-partner's share of the re- ability company classified as a partner- excluded if the participants in the joint pro- maining profits allocated to donated ship, or duction, extraction, or use of property: capital must not be proportionately greater than the donor's share attribut- 2) At least 50% of the total interest in part- 1) Own the property as co-owners, either able to the donor's capital. nership capital and profits is sold or ex- in fee or under lease or other form of Page 3 contract granting exclusive operating Testing day. The partnership deter- rights, mines if there is a majority interest tax Months Interest year on the testing day, which is usually Year End Year Profits of × 2) Reserve the right separately to take in the first day of the partnership's current 12/31: End Interest Deferral Deferral kind or dispose of their shares of any tax year. Rose ...... 12/31 0.5 -0- -0- property produced, extracted, or used, Change in tax year. If a partnership's Irene ...... 11/30 0.5 11 5.5 and majority interest tax year changes, it will Total Deferral ...... 5.5 not be required to change to another tax 3) Do not jointly sell services or the prop- year for 2 years following the year of erty produced or extracted. Each sepa- Months Interest change. Year End Year Profits of × rate participant can delegate authority to 11/30: End Interest Deferral Deferral sell his or her share of the property 2) Principal partner. If there is no majority produced or extracted for the time being Rose ...... 12/31 0.5 1 0.5 interest tax year, the partnership must Irene ...... 11/30 0.5 -0- -0- for his or her account, but not for a pe- use the tax year of all its principal part- Total Deferral ...... 0.5 riod of time in excess of the minimum ners. A principal partner is one who has needs of the industry, and in no event for a 5% or more interest in the profits or more than one year. However, this does capital of the partnership. not apply to an unincorporated organ- ization one of whose principal purposes 3) Least aggregate deferral of income. If Procedures. Generally, determination of the is cycling, manufacturing, or processing there is no majority interest tax year and partnership's required tax year is made at the for persons who are not members of the the principal partners do not have the beginning of the partnership's current tax organization. same tax year, the partnership generally year. However, the IRS can require the part- must use a tax year that results in the nership to use another day or period that will more accurately reflect the ownership of the Electing the exclusion. An eligible organ- least aggregate deferral of income to the partnership. ization that wishes to be excluded from the partners. The change to a required tax year is partnership rules must make the election not treated as initiated by the partnership with the later than the time for filing the partnership consent of the IRS. No formal application for return for the first tax year for which exclusion Least aggregate deferral of income. The a change in tax year is needed. is desired. See section 1.761–2(b) of the In- tax year that results in the least aggregate Notifying IRS. Any partnership that come Tax Regulations for the procedures to deferral of income is determined as follows: changes to a required tax year must notify the follow. IRS by writing at the top of the first page of 1) Determine the number of months of its tax return for its first required tax year, deferral for each partner using one part- “FILED UNDER SECTION 806 OF THE TAX ner's tax year. Find the months of REFORM ACT OF 1986.” deferral by counting the months from the Short period return. When a partnership Tax Year end of that tax year forward to the end changes its tax year, a short period return of each other partner's tax year. Taxable income is figured on the basis of a must be filed. The short period return covers tax year. A “tax year” is the accounting period the months between the end of the partner- 2) Multiply each partner's months of defer- ship's prior tax year and the beginning of its used for keeping records and reporting in- ral determined in step (1) by that part- come and expenses. new tax year. ner's share of interest in the partnership If a partnership changes to the tax year profits for the tax year used in step (1). resulting in the least aggregate deferral of in- Partnership. A partnership determines its come, a statement must be attached to the tax year as if it were a taxpayer. However, 3) Add the amounts in step (2) to get the short period return showing the computations there are limits on the year it can choose. In aggregate (total) deferral for the tax year used to determined that tax year. The short general, a partnership must use its required used in step (1). period return must indicate at the top of page tax year. Exceptions to this rule are discussed 1, “FILED UNDER SECTION 1.706–1T.” under Exceptions to Required Tax Year, later. 4) Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years. Partners. Partners can change their tax year Exceptions to Required only if they receive permission from the IRS. This also applies to corporate partners who The partner's tax year that results in the Tax Year are usually allowed to change their account- lowest number in step (3) above is the tax year that must be used by the partnership. If There are two exceptions to the required tax ing periods without prior approval if they meet year rule. certain conditions. more than one year qualifies as the tax year that has the least aggregate deferral of in- come, the partnership can choose any year Closing of tax year. Generally, the partner- that qualifies. However, if one of the years Business purpose tax year. If a partnership ship's tax year is not closed because of the that qualifies is the partnership's existing tax establishes an acceptable business purpose sale, exchange, or liquidation of a partner's year, the partnership must retain that tax for having a tax year different from its required interest, the death of a partner, or the entry year. tax year, the different tax year can be used. of a new partner. However, if a partner sells, Special de minimis rule. If the tax year The deferral of income to the partners is not exchanges, or liquidates his or her entire in- that results in the least aggregate deferral considered a business purpose. terest, the partnership's tax year is closed for produces an aggregate deferral that is less See Business Purpose Tax Year in Publi- that partner. See Distributive Share in Year than 0.5 when compared to the aggregate cation 538 for more information. of Disposition under Disposition of Partner's deferral of the current tax year, the partner- Interest, later. ship's current tax year is treated as the tax year with the least aggregate deferral. Section 444 election. Partnerships can elect under section 444 of the Internal Revenue Code to use a tax year different from both the Required Tax Year Example. Rose and Irene each have a required tax year and any business purpose 50% interest in a partnership that uses a fiscal tax year. Certain restrictions apply to this A partnership generally must conform its tax year ending June 30. Rose uses a calendar year to its partners' tax years as follows: election. In addition, the electing partnership year while Irene has a fiscal year ending No- may be required to make a payment repre- vember 30. The partnership must change its senting the value of the extra tax deferral to 1) Majority interest tax year. If one or tax year to a fiscal year ending November 30 the partners. more partners having the same tax year because this results in the least aggregate See Section 444 Election in Publication own an interest in partnership profits and deferral of income to the partners. This was 538 for more information. capital of more than 50% (a majority in- determined as shown in the following table. terest), the partnership must use the tax year of those partners. Page 4 Certain small partnerships (with 10 or fewer However, certain penalties may not be partners) meet this reasonable cause test if: imposed if there is reasonable cause for Partnership Return noncompliance. 1) All partners are individuals (other than (Form 1065) nonresident aliens), estates, or C corpo- Each partnership engaged in a trade or busi- rations, ness must file a return on Form 1065 showing 2) All partners have timely filed income tax Partnership Income its income, deductions, and other required returns fully reporting their shares of the information. In addition, the partnership return partnership's income, deductions, and or Loss shows the names and addresses of each credits, and partner and each partner's distributive share A partnership computes its income and files of taxable income. This is an information re- 3) The partnership has not elected to be its return in the same manner as an individual. turn and must be signed by a general partner. subject to the rules for consolidated audit However, certain deductions are not allowed If a limited liability company is treated as a proceedings (explained later under Part- to the partnership. partnership, it must file Form 1065 and one ner's Distributive Share, in the dis- of its members must sign the return. cussion Reporting Distributive Share). Separately stated items. Certain items must The first return of the partnership is not be separately stated on the partnership return required to be filed until the first tax year the For partnership tax years ending be- and included as separate items on the part- partnership has income or deductions. The ! fore August 6, 1997, a small partner- ners' returns. These items, listed on Schedule partnership is not required to file Form 1065 CAUTION ship met this reasonable cause test K (Form 1065), are: for any tax year it receives no income and has if: no expenses. It is not considered to be en- 1) Ordinary income or loss from trade or gaged in a trade or business that year. See 1) All partners were individuals (other than business activities. nonresident aliens) or estates, the instructions for Form 1065 for more infor- 2) Net income or loss from rental real es- mation. 2) The partnership did not make a special tate activities. allocation of any partnership item, and 3) Net income or loss from other real estate Due date. Form 1065 generally must be filed activities. by April 15 following the close of the partner- 3) The requirements in (2) and (3) above ship's tax year if its accounting period is the were met. 4) Gains and losses from sales or ex- calendar year. A fiscal year partnership gen- changes of capital assets. erally must file its return by the 15th day of the The failure to file penalty is assessed 4th month following the close of its fiscal year. against the partnership. However, each part- 5) Gains and losses from sales or ex- If a partnership needs more time to file its ner is individually liable for the penalty to the changes of section 1231 property. extent the partner is liable for partnership return, it should file Form 8736 by the regular 6) Charitable contributions. due date of its Form 1065. The automatic debts in general. extension is 3 months. If the partnership wants to contest the 7) Dividends (passed through to corporate If the partnership has made a section 444 penalty, it must pay the penalty and sue for partners) that qualify for the dividends- election to use a tax year other than a re- refund in a U.S. District Court or the U.S. received deduction. quired year, an automatic extension of time Court of Federal Claims. 8) Taxes paid or accrued to foreign coun- for filing a return will run concurrently with any tries and U.S. possessions. extension of time allowed by the section 444 Failure to furnish copies to the partners. election. The filing of an application for ex- The partnership must furnish copies of 9) Other items of income, gain, loss, de- tension does not extend the time for making Schedule K–1 to the partners. A penalty for duction, or credit, as provided by regu- the payment of any tax due on a partner's each statement not furnished will be as- lations. Examples include nonbusiness personal income tax return, nor does it extend sessed against the partnership unless the expenses, intangible drilling and devel- the time for filing a partner's personal income failure to do so is due to reasonable cause opment costs, and soil and water con- tax return. and not willful neglect. servation expenses. If the date for filing a return or making a tax payment falls on a Saturday, Sunday, or Trust fund recovery penalty. A person re- Elections. The partnership makes most legal holiday, the partnership can file the re- sponsible for withholding, accounting for, or choices about how to compute income. These turn or make the payment on the next busi- depositing or paying withholding taxes who include choices for: ness day. willfully fails to do so can be held liable for a penalty equal to the tax not paid, plus interest. 1) Accounting methods. “Willfully” in this case means voluntarily, Schedule K–1 due to partners. The part- 2) Depreciation methods. nership must furnish copies of Schedule K–1 consciously, and intentionally. Paying other (Form 1065) to the partners by the date Form expenses of the business instead of the taxes 3) Accounting for specific items, such as 1065 is required to be filed, including exten- due is considered willful behavior. depletion or installment sales. sions. A responsible person can be an officer of a corporation, a partner, a sole proprietor, or 4) Nonrecognition of gain on involuntary an employee of any form of business. This conversions of property. may include a trustee or agent with authority over the funds of the business. 5) Amortization of certain organization fees and business start-up costs of the part- Penalties nership. Other penalties. Criminal penalties can be To help ensure that returns are filed correctly imposed for willful failure to file, tax evasion, However, each partner chooses how to and on time, the law provides penalties for or making a false statement. failure to do so. treat the partner's share of foreign and U.S. Other penalties include those for: possessions taxes, certain mining exploration expenses, and income from cancellation of Failure to file. A penalty is assessed against 1) Not supplying a taxpayer identification debt. any partnership that must file a partnership number. More information. For more information return and fails to file on time, including ex- 2) Not furnishing information returns. on the following topics, see the listed publi- tensions, or fails to file a return with all the cation. information required. The penalty is $50 times 3) Overstating tax deposit claims. the total number of partners in the partnership 1) Accounting methods: Publication 538. during any part of the tax year for each month 4) Underpaying tax due to a valuation mis- (or part of a month) the return is late or in- statement. 2) Depreciation methods: Publication 946. complete, up to 5 months. 5) Not furnishing information on tax shel- 3) Installment sales: Publication 537. The penalty will not be imposed if the ters. partnership can show reasonable cause for 4) Amortization and depletion: Publication its failure to file a complete or timely return. 6) Promoting abusive tax shelters. 535, chapters 12 and 13. Page 5 5) Involuntary conversions: Publication 544 3) Filing fees. Partner's interest in partnership. If a part- (condemnations) and Publication 547 ner's distributive share of a partnership item (casualties and thefts). Expenses not amortizable. Expenses cannot be determined under the partnership that cannot be amortized (regardless of how agreement, it is determined by his or her in- Organization expenses and syndication the partnership characterizes them) include terest in the partnership. The partner's inter- fees. Neither the partnership nor any partner expenses connected with: est is determined by taking all of the following can deduct, as a current expense, amounts into account. paid or incurred to organize a partnership or 1) Acquiring assets for the partnership or to promote the sale of, or to sell, an interest transferring assets to the partnership. 1) The partner's contributions to the part- in the partnership. nership. The partnership can choose to amortize 2) Admitting or removing partners other 2) The interests of all partners in economic certain organization expenses over a period than at the time the partnership is first profits and losses (if different from inter- of not less than 60 months. The period must organized. ests in taxable income or loss) and in start with the month the partnership begins 3) Making a contract relating to the opera- cash flow and other nonliquidating dis- business. This election is irrevocable and the tion of the partnership trade or business tributions. period the partnership chooses in this election (even if the contract is between the cannot be changed. If the partnership elects 3) The rights of the partners to distributions partnership and one of its members). to amortize these expenses and is liquidated of capital upon liquidation. before the end of the amortization period, the 4) Syndicating the partnership. Syndication Gross income. When it is necessary to de- remaining balance in this account may be expenses, such as commissions, pro- termine the gross income of a partner, the deductible as a loss. fessional fees, and printing costs con- partner's gross income includes his or her Making the election. The election to nected with the issuing and marketing distributive share of the partnership's gross amortize organization expenses is made by of interests in the partnership, are capi- income. For example, the partner's share of attaching a statement to the partnership's re- talized. They can never be deducted by the partnership gross income is used in de- turn for the tax year the partnership begins its the partnership, even if the syndication termining whether an income tax return must business. The statement must provide all the is unsuccessful. following information: be filed by that partner.

1) A description of each organization ex- Estimated tax. Partners may have to make pense incurred (whether or not paid). payments of estimated tax as a result of partnership income. 2) The amount of each expense. Partner's Distributive Generally, the required estimated tax 3) The date each expense was incurred. payment for individuals is the smaller of: 4) The month the partnership began its Share 1) 90% of the tax to be shown on the cur- business. A partner's taxable income for a tax year in- rent year's tax return, or cludes his or her distributive share of certain 5) The number of months (not less than 60) 2) 100% of the total tax shown on the prior partnership items for the partnership's tax year's tax return. over which the expenses are to be year ending with or within the partner's tax amortized. year. A different rule applies to individuals who A cash basis taxpayer must also indicate receive at least two-thirds of their gross in- the amount paid before the end of the year Partnership agreement. Generally, the come from farming or fishing. for each expense. Expenses less than $10 partnership agreement determines a partner's See Publication 505 for more information. need not be separately listed, provided the distributive share of any item or class of items total amount is listed with the dates on which of income, gain, loss, deduction, or credit. Self-employment tax. A partner is not an the first and last of the expenses were in- The allocations provided for in the partnership employee of the partnership. The partner's curred. agreement or any modification will be disre- distributive share of ordinary income from a Amortizable expenses. Amortization garded if they do not have substantial eco- partnership is generally included in figuring applies to expenses that are: nomic effect. If an allocation does not have net earnings from self-employment. However, substantial economic effect or the partnership a limited partner generally does not include 1) Incident to the creation of the partner- agreement does not provide for the allocation, his or her distributive share of income or loss ship, the partner's distributive share of the part- in computing net earnings from self- employment. This exclusion does not apply 2) Chargeable to a capital account, and nership items is determined by the partner's interest in the partnership. to guaranteed payments made to a limited 3) The type that would be amortized if they Substantial economic effect. An allo- partner for services actually rendered to or were incurred in the creation of a part- cation has substantial economic effect if both on behalf of a partnership engaged in a trade nership having a fixed life. of the following apply: or business. If an individual partner has net earnings from self-employment of $400 or To satisfy (1) and (2) above, an expense 1) There is a reasonable possibility that the more for the year, the partner must figure must be incurred during the period beginning allocation will substantially affect the self-employment tax on Schedule SE (Form at a point which is a reasonable time before dollar amount of the partners' shares of 1040). For more information on self- the partnership begins business and ending partnership income or loss independ- employment tax, see Publication 533. with the date for filing the partnership return ently of tax consequences. (not including extensions) for the tax year in Alternative minimum tax. To figure alter- which the partnership begins business. In 2) The partner to whom the allocation is native minimum tax, a partner must sepa- addition, the expense must be for creating the made actually receives the economic rately take into account any distributive share partnership and not for starting or operating benefit or bears the economic burden of items of income and deductions that enter the partnership trade or business. corresponding to that allocation. into the computation of alternative minimum To satisfy (3) above, the expense must taxable income. For information on which be for a type of item normally expected to Nonrecourse liability. A nonrecourse liability items of income and deductions are affected, benefit the partnership throughout its entire is one for which no partner or related person see the Form 6251 instructions. life. has an economic risk of loss. An allocation Organization expenses that can be amor- of a loss, deduction, or partnership expense tized include: Reporting Distributive attributable to nonrecourse liabilities not Share 1) Legal fees for services incident to the deductible or chargeable to capital cannot organization of the partnership, such as have economic effect. A partner's share of A partner must report his or her distributive negotiation and preparation of a part- nonrecourse deductions is determined by his share of partnership items on his or her tax nership agreement. or her interest in the partnership. For the rules return, whether or not it is actually distributed. on allocating nonrecourse deductions, see However, a partner's distributive share of a 2) Accounting fees for services incident to section 1.704–2 of the Income Tax Regu- loss may be limited. See Limits on Losses, the organization of the partnership. lations. later. These items are reported to the partner Page 6 on Schedule K–1 (Form 1065). See the Part- Passive activities. Generally, section 469 ner's Instructions for Schedule K–1 (Form Limits on Losses of the Internal Revenue Code limits the 1065) for more information. amount a partner can deduct for passive ac- To determine the allowable amount of any Partner's adjusted basis. A partner's dis- tivity losses and credits. The passive activity deduction or exclusion subject to a limit, a tributive share of partnership loss is allowed limits do not apply to the partnership. Instead, partner must combine any separate de- only to the extent of the adjusted basis of the they apply to each partner's share of loss or ductions or exclusions on his or her income partner's partnership interest. The adjusted credit from passive activities. Because the tax return with the distributive share of part- basis is figured at the end of the partnership's treatment of each partner's share of partner- nership deductions or exclusions before ap- tax year in which the loss occurred, before ship income, loss, or credit depends on the plying the limit. taking the loss into account. Any loss more nature of the activity that generated it, the than the partner's adjusted basis is not partnership must report income, loss, and deductible for that year. However, any loss credits separately for each activity. Character of items. The character of each not allowed for this reason will be allowed as Generally, passive activities include a item of income, gain, loss, deduction, or credit a deduction (up to the partner's basis) at the trade or business activity in which the partner included in a partner's distributive share is end of any succeeding year in which the does not materially participate. The level of determined as if the partner: partner increases his or her basis to more each partner's participation must be deter- than zero. See Basis of Partner's Interest, mined by the partner. 1) Realized the item directly from the same later. Rental activities. Passive activities also source as the partnership, or include rental activities, regardless of the Example. Mike and Joe are equal part- partner's participation. However, a rental real 2) Incurred the item in the same manner ners in a partnership. Mike files his individual estate activity in which the partner materially as the partnership. return on a calendar year basis. The partner- participates is not considered a passive ac- ship return is also filed on a calendar year tivity. The partner must also meet both of the For example, a partner's distributive share basis. The partnership incurred a $10,000 following conditions for the tax year: of gain from the sale of partnership depre- loss last year and Mike's distributive share of 1) More than half of the personal services ciable property used in the trade or business the loss is $5,000. The adjusted basis of his the partner performs in any trade or of the partnership is treated as gain from the partnership interest before considering his business are in a real property trade or sale of depreciable property the partner used share of last year's loss was $2,000. He could business in which the partner materially in a trade or business. claim only $2,000 of the loss on last year's individual return. The adjusted basis of his participates. interest at the end of last year was then re- 2) The partner performs more than 750 Inconsistent treatment of items. Partners duced to zero. hours of service in real property trades must generally treat partnership items the The partnership showed an $8,000 profit or businesses in which the partner same way on their individual tax returns as for this year. Mike's $4,000 share of the profit materially participates. they are treated on the partnership return. If increased the adjusted basis of his interest a partner treats an item differently on his or by $4,000 (not taking into account the $3,000 Limited partners. Limited partners are her individual return, the IRS can immediately excess loss he could not deduct last year). generally not considered to materially partic- assess and collect any tax and penalties that His return for this year will show his $4,000 ipate in trade or business activities conducted result from adjusting the item to make it con- distributive share of this year's profits and the through partnerships. sistent with the partnership return. However, $3,000 loss not allowable last year. The ad- More information. For more information this rule will not apply if a partner identifies the justed basis of his partnership interest at the on passive activities, see Publication 925 and different treatment by filing Form 8082, No- end of this year is $1,000. the instructions to Forms 1065 and 8582. tice of Inconsistent Treatment or Administra- tive Adjustment Request (AAR), with his or her return. Not-for-profit activity. Deductions relating Partner's Exclusions and to an activity not engaged in for profit are limited. For a discussion of the limits, see Deductions Consolidated audit procedures. Under chapter 1 in Publication 535. Cancellation of qualified real property current examination procedures, the tax business debt. A partner other than a C treatment of any partnership item is deter- corporation can elect to exclude from gross mined at the partnership level in a consol- At-risk limits. At-risk rules apply to most income the partner's distributive share of in- idated audit proceeding, rather than at the trade or business activities, including activ- come from cancellation of the partnership's individual partner's level. After the proper ities conducted through a partnership. The qualified real property business debt. This is treatment is determined at the partnership at-risk rules limit a partner's deductible loss a debt (other than a qualified farm debt) in- level, the IRS can automatically make related to the amounts for which that partner is con- curred or assumed by the partnership in adjustments to the tax returns of the partners, sidered at risk in the activity. connection with real property used in its trade based on their share of the adjusted items. A partner is considered at risk for: or business and secured by that property. A The consolidated audit procedures do not debt incurred or assumed after 1992 qualifies apply to certain small partnerships (with 10 1) The money and adjusted basis of any only if it was incurred or assumed to acquire, or fewer partners) if each partner is either: property he or she contributed to the activity. construct, reconstruct, or substantially im- prove such property. A debt incurred to refi- 1) An individual (other than a nonresident 2) The partner's share of net income re- nance a qualified real property business debt alien), tained by the partnership. qualifies, but only up to the refinanced debt. A partner who elects the exclusion must 2) A C corporation, or 3) Certain amounts borrowed by the part- reduce the basis of his or her depreciable real nership for use in the activity if the part- property by the amount excluded. For this 3) An estate of a deceased partner. ner is personally liable for repayment or purpose, a partnership interest is treated as the amounts borrowed are secured by depreciable real property to the extent of the However, small partnerships can make an the partner's property (other than prop- partner's share of the partnership's deprecia- election to have these procedures apply. erty used in the activity). ble real property. However, a partnership in- terest cannot be treated as depreciable real For partnership tax years ending be- A partner is not considered at risk for property unless the partnership makes a cor- ! fore August 6, 1997, these proce- amounts protected against loss through responding reduction in the basis of its CAUTION dures do not apply to small partner- guarantees, stop-loss agreements, or similar depreciable real property with respect to that ships if both of the following applied: arrangements. Nor is the partner at risk for partner. amounts borrowed if the lender has an inter- To elect the exclusion, the partner must 1) Each partner was an individual (other est in the activity (other than as a creditor) file Form 982 with his or her original income than a nonresident alien) or an estate. or is related to a person (other than the part- tax return. If the election is not made on that ner) having such an interest. return, a partner may request permission to 2) The partnership did not make a special For more information on determining the make a late election, but must show that he allocation of any partnership item. amount at risk, see Publication 925. or she acted reasonably and in good faith and Page 7 that granting relief will not prejudice the in- Limits. The section 179 deduction is funds. See chapter 8 in Publication 535 for terests of the government. For more informa- subject to certain limits that apply to the more information on the allocation of interest tion on making a late election, see sections partnership and to each partner. The part- expense related to debt-financed distribu- 301.9100–1T through 301.9100–3T of the nership determines its section 179 deduction tions. Temporary Procedure and Administration subject to the limits. It then allocates the de- Regulations. duction among its partners. Debt-financed acquisitions. The interest Exclusion limit. The partner's exclusion Each partner adds the amount allocated expense on loan proceeds used to purchase cannot be more than the smaller of the fol- from the partnership (shown on Schedule an interest in, or make a contribution to, a lowing two amounts. K–1) to his or her other nonpartnership sec- partnership must be allocated as explained in tion 179 costs and then applies the maximum chapter 8 of Publication 535. 1) The partner's share of the excess (if any) dollar limit to this total. To determine if a of: partner has exceeded the $200,000 invest- ment limit, the partner does not include any a) The outstanding principal of the of the cost of section 179 property placed in Partnership debt immediately before the can- service by the partnership. After the maximum cellation, over dollar limit and investment limit are applied, Distributions the remaining cost of the partnership and b) The fair market value (as of that Partnership distributions include the following: time) of the property securing the nonpartnership section 179 property is sub- debt, reduced by the outstanding ject to the taxable income limit. 1) A withdrawal by a partner in anticipation principal of other qualified real Figuring partnership's taxable income. of the current year's earnings. property business debt secured by For purposes of the taxable income limit, 2) A distribution of the current year's or that property (as of that time). taxable income of a partnership is figured by adding together the net income (or loss) from prior years' earnings not needed for 2) The total adjusted bases of depreciable all trades or businesses actively conducted working capital. real property held by the partner imme- by the partnership during the tax year. 3) A complete or partial liquidation of a diately before the cancellation (other Figuring partner's taxable income. For partner's interest. than property acquired in contemplation purposes of the taxable income limit, the tax- of the cancellation). able income of a partner who is engaged in 4) A distribution to all partners in a com- the active conduct of one or more of a part- plete liquidation of the partnership. Effect on partner's basis. Because of nership's trades or businesses includes his A partnership distribution is not taken into offsetting adjustments, the cancellation of a or her allocable share of taxable income de- account in determining the partner's distribu- partnership debt does not usually cause a net rived from the partnership's active conduct of tive share of partnership income or loss. If any change in the basis of a partnership interest. any trade or business. gain or loss from the distribution is recognized Each partner's basis is: Basis adjustment. A partner who is al- by the partner, it must be reported on his or located section 179 expenses from the part- her return for the tax year in which the distri- 1) Increased by his or her share of the nership must reduce the basis of his or her bution is received. Money or property with- partnership income from the cancellation partnership interest by the total section 179 drawn by a partner in anticipation of the cur- of debt (whether or not the partner ex- expenses allocated, regardless of whether rent year's earnings is treated as a distribution cludes the income), and the full amount allocated can be currently received on the last day of the partnership's deducted. See Adjusted Basis under Basis 2) Reduced by the deemed distribution re- tax year. sulting from the reduction in his or her of Partner's Interest, later. If a partner dis- poses of his or her interest in a partnership, share of partnership liabilities. Effect on partner's basis. A partner's ad- the partner's basis for determining gain or justed basis in his or her partnership interest loss is increased by any outstanding carry- (See Adjusted Basis under Basis of Partner's is decreased (but not below zero) by the over of disallowed deductions of section 179 Interest, later.) The basis of a partner's inter- money and adjusted basis of property dis- expenses allocated from the partnership. est will change only if the partner's share of tributed to the partner. See Adjusted Basis The basis of a partnership's section 179 income is different from the partner's share under Basis of Partner's Interest, later. of debt. property must be reduced by the section 179 deduction elected by the partnership. This As explained earlier, however, a partner's Effect on partnership. A partnership gen- reduction of basis must be made even if any election to exclude income from the cancel- erally does not recognize any gain or loss partner cannot deduct his or her entire lation of debt may reduce the basis of the because of distributions it makes to partners. allocable share of the section 179 deduction partner's interest to the extent the interest is The partnership may be able to elect to adjust because of the limits. treated as depreciable real property. the basis of its undistributed property, as ex- More information. See Publication 946 Basis of depreciable real property re- plained later under Adjusting the Basis of for more information on the section 179 de- duced. If the basis of depreciable real prop- Partnership Property. erty is reduced, and the property is disposed duction. of, then for purposes of determining recapture Certain distributions treated as a sale or under section 1250 of the Internal Revenue Partnership expenses paid by partner. In exchange. When a partnership distributes Code: general, a partner cannot deduct partnership the following items, the distribution may be expenses paid out of personal funds unless treated as a sale or exchange of property 1) Any such basis reduction is treated as a the partnership agreement requires the part- rather than a distribution. deduction allowed for depreciation, and ner to pay the expenses. These expenses are usually considered incurred and deductible 1) Unrealized receivables or substantially 2) The determination of what would have appreciated inventory items to a partner been the depreciation adjustment under by the partnership. If an employee of the partnership performs in exchange for any part of the partner's the straight line method is made as if interest in other partnership property, in- there had been no such reduction. part of a partner's duties and the partnership agreement requires the partner to pay the cluding money. Therefore, the basis reduction recaptured employee out of personal funds, the partner 2) Other property (including money) in ex- as ordinary income is reduced over the time can deduct the payment as a business ex- change for any part of a partner's interest the partnership continues to hold the property, pense. in unrealized receivables or substantially as the partnership forgoes depreciation de- appreciated inventory items. ductions due to the basis reduction. Interest expense for distributed loan. If the See Payments for Unrealized Receivables More information. See chapter 5 in partnership distributes borrowed funds to a and Inventory Items under Disposition of Publication 334 for more information on partner, the partnership should list the part- Partner's Interest, later. qualified real property business debt. ner's share of interest expense for these This treatment does not apply in the fol- funds as “Interest expense allocated to debt- lowing situations: Section 179 deduction. A partner can elect financed distributions” under “Other de- to deduct all or part of the cost of certain as- ductions” on the partner's Schedule K–1. The 1) A distribution of property to the partner sets under section 179 of the Internal Reve- partner deducts this interest on his or her tax who contributed the property to the nue Code. return depending on how the partner uses the partnership. Page 8 2) Certain payments made to a retiring 3) The distribution is in money, unrealized For these rules, the term “money” includes partner or successor in interest of a de- receivables, or inventory items. marketable securities treated as money, as ceased partner. discussed earlier. There are exceptions to these general Effect on basis. The adjusted basis of rules. See the following discussions. Also, the partner's interest in the partnership is in- Partner's Gain or Loss see Liquidation at Partner's Retirement or creased by any net precontribution gain rec- A partner generally recognizes gain on a Death under Disposition of Partner's Interest, ognized by the partner. Other than for pur- partnership distribution only to the extent any later. poses of determining the gain, the increase money (and marketable securities treated as is treated as occurring immediately before the money) included in the distribution exceeds Distribution of partner's debt. If a partner- distribution. See Basis of Partner's Interest, the adjusted basis of the partner's interest in ship acquires a partner's debt and extin- later. the partnership. Any gain recognized is gen- guishes the debt by distributing it to the part- The partnership must adjust its basis in erally treated as capital gain from the sale of ner, the partner will recognize capital gain or any property the partner contributed within 5 the partnership interest on the date of the loss to the extent the fair market value of the years (7 years for property contributed after distribution. If partnership property (other than debt differs from the basis of the debt (deter- June 8, 1997) of the distribution to reflect any marketable securities treated as money) is mined under the rules discussed in Partner's gain that partner recognizes under this rule. distributed to a partner, he or she generally Basis for Distributed Property, later). Exceptions. If any of the distributed does not recognize any gain until the sale or The partner is treated as having satisfied property is property the partner had contrib- other disposition of the property. the debt for its fair market value. If the issue uted to the partnership, the property is not For exceptions to these rules, see Distri- price (adjusted for any premium or discount) taken into account in determining either of the bution of partner's debt and following dis- of the debt exceeds its fair market value when following. cussions, later. Also, see Payments for Un- distributed, the partner may have to include 1) The excess of the fair market value of realized Receivables and Inventory Items that amount in income as canceled debt. any property received over the adjusted under Disposition of Partner's Interest, later. Similarly, a deduction may be available to basis of the partner's interest in the a corporate partner if the fair market value of partnership. Example. The adjusted basis of Jo's the debt at the time of distribution exceeds its partnership interest is $14,000. She receives adjusted issue price. 2) The partner's net precontribution gain. a distribution of $8,000 cash and land that has an adjusted basis of $2,000 and a fair market Net precontribution gain. A partner gener- If any interest in an entity is distributed, this value of $3,000. Because the cash received ally must recognize gain on the distribution exception does not apply to the extent that the does not exceed the basis of her partnership of property (other than money) if the partner value of the interest is due to property con- interest, Jo does not recognize any income contributed appreciated property to the part- tributed to the entity after the interest in the on the distribution. Any gain on the land will nership during the 5-year period before the entity had been contributed to the partnership. be recognized when she sells or otherwise distribution. Recognition of gain under this rule also disposes of it. The distribution decreases the does not apply to a distribution of either: adjusted basis of Jo's partnership interest to A 7-year period applies to property $4,000 [$14,000 − ($8,000 + $2,000)]. ! contributed after June 8, 1997, except 1) Unrealized receivables or substantially CAUTION property contributed under a written appreciated inventory items of the part- Marketable securities treated as money. binding contract: nership, discussed later, in exchange for Generally, a marketable security distributed all or part of a partner's interest in other to a partner after December 8, 1994, is 1) That was in effect on June 8, 1997, and partnership property. treated as money in determining whether gain at all times thereafter before the contri- 2) Other partnership property in exchange is recognized on the distribution. This treat- bution, and for all or part of a partner's interest in ment, however, does not generally apply if unrealized receivables or substantially that partner contributed the security to the 2) That provides for the contribution of a fixed amount of property. appreciated inventory items of the part- partnership or an investment partnership nership. made the distribution to an eligible partner. The amount treated as money is the se- The gain recognized is the lesser of: curity's fair market value when distributed, 1) The excess of: Partner's Basis for reduced (but not below zero) by the excess Distributed Property (if any) of: a) The fair market value of the prop- erty received in the distribution, Unless there is a complete liquidation of a 1) The partner's distributive share of the over partner's interest, the basis of property (other gain that would be recognized had the than money) distributed to the partner by a partnership sold all its marketable secu- b) The adjusted basis of the partner's partnership is its adjusted basis to the part- rities of the same class and issuer as the interest in the partnership imme- nership immediately before the distribution. distributed security at their fair market diately before the distribution, re- However, the basis of the property to the value immediately before the transaction duced (but not below zero) by any partner cannot be more than the adjusted resulting in the distribution, over money received in the distribution, basis of his or her interest in the partnership or reduced by any money received in the same 2) The partner's distributive share of the transaction. gain that would be recognized had the 2) The “net precontribution gain” of the partnership sold all such securities it still partner. This is the net gain the Example 1. The adjusted basis of Beth's held after the distribution at the fair distributee partner would recognize if all partnership interest is $30,000. She receives market value in (1). the property contributed by the partner a distribution of property that has an adjusted within 5 years (7 years for property con- basis of $20,000 to the partnership and For the definition of marketable securities tributed after June 8, 1997) of the distri- $4,000 in cash. Her basis for the property is and other information, see section 731(c) of bution, and held by the partnership im- $20,000. the Internal Revenue Code. mediately before the distribution, were distributed to another partner, other than Example 2. The adjusted basis of Mike's partnership interest is $10,000. He receives Loss on distribution. A partner does not a partner who owns more than 50% of a distribution of $4,000 cash and property that recognize loss on a partnership distribution the partnership. See Distribution of con- has an adjusted basis to the partnership of unless all of the following requirements are tributed property to another partner un- $8,000. His basis for the distributed property met: der Contribution of Property, later. is limited to $6,000 ($10,000 − $4,000, the cash he receives). 1) The adjusted basis of the partner's in- The character of the gain is determined terest in the partnership exceeds the by reference to the character of the net pre- distribution. contribution gain. This gain is in addition to Complete liquidation of partner's interest. any gain the partner must recognize if the The basis of property received in complete 2) The partner's entire interest in the part- money distributed is more than his or her liquidation of a partner's interest is the ad- nership is liquidated. basis in the partnership. justed basis of the partner's interest in the Page 9 partnership reduced by any money distributed Allocating a basis decrease. Allocate nership of $12,000, and unrealized receiv- to the partner in the same transaction. any basis decrease required in rule (1) or rule ables having a basis to the partnership of (2) above as follows: $8,000. The basis of her partnership interest Partner's holding period. A partner's hold- is first reduced to $6,000 by the $12,000 cash 1) Allocate the basis decrease first to items ing period for property distributed to the part- she receives. This $6,000 basis is then di- with unrealized depreciation to the extent ner includes the period the property was held vided proportionately between the inventory of the unrealized depreciation. (If the by the partnership. If the property was con- items and the unrealized receivables. Her basis decrease is less than the total un- tributed to the partnership by a partner, then basis for the inventory items is $3,600 realized depreciation, allocate it among ÷ × the period it was held by that partner is also [(12,000 20,000) $6,000]. Her basis for those items in proportion to their re- included. the unrealized receivables is $2,400 [(8,000 spective amounts of unrealized depreci- ÷ 20,000) × $6,000]. ation.) Basis divided among properties. If the Partner's interest more than partner- 2) Allocate any remaining basis decrease basis of property received is the adjusted ship basis. If the basis of a partner's interest among all the items in proportion to their basis of the partner's interest in the partner- to be divided in a complete liquidation of the respective assigned basis amounts (as ship (reduced by money received in the same partner's interest is more than the partner- decreased in (1)). transaction), it must be divided among the ship's adjusted basis for the unrealized properties distributed to the partner. For Example. Tom's basis in his partnership receivables and inventory items distributed, properties distributed after August 5, 1997, and if no other property is distributed to which allocate the basis using the following rules. interest is $20,000. In a distribution in liqui- dation of his entire interest, he receives the partner can apply the remaining basis, the properties C and D, neither of which is in- partner has a capital loss to the extent of the 1) Allocate the basis first to unrealized remaining basis of the partnership interest. receivables and inventory items included ventory or unrealized receivables. Property in the distribution by assigning a basis C has an adjusted basis to the partnership to each item equal to the partnership's of $15,000 and a fair market value of $15,000. Special adjustment to basis of property adjusted basis in the item immediately Property D has an adjusted basis to the received. A partner who acquired any part before the distribution. If the total of partnership of $15,000 and a fair market of his or her partnership interest in a sale or these assigned bases exceeds the value of $5,000. exchange or upon the death of another part- allocable basis, decrease the assigned To figure his basis in each property, Tom ner may be able choose a special basis ad- bases by the amount of the excess. first assigns bases of $15,000 to property A justment for the property. In order for the and $15,000 to property B (their adjusted partner to choose the special adjustment, the 2) Allocate any remaining basis to proper- bases to the partnership). This leaves a distribution must be made within 2 years after ties other than unrealized receivables $10,000 basis decrease (the $30,000 total of the partner acquired the partnership interest. and inventory items by assigning a basis the assigned bases minus the $20,000 Also, the partnership must not have chosen to each property equal to the partner- allocable basis). He allocates the entire the optional adjustment to basis, discussed ship's adjusted basis in the property im- $10,000 to property D (its unrealized depre- later under Adjusting the Basis of Partnership mediately before the distribution. If the ciation). Tom's basis in property C is $15,000 Property, when the partner acquired the allocable basis exceeds the total of and his basis in property D is $5,000 ($15,000 partnership interest. these assigned bases, increase the as- − $10,000). If a partner chooses this special basis signed bases by the amount of the ex- adjustment, the partner's basis for the prop- cess. If the total of these assigned bases Distributions before August 6, 1997. erty distributed is the same as it would have exceeds the allocable basis, decrease For properties distributed before August 6, been if the partnership had chosen the op- the assigned bases by the amount of the 1997, allocate the basis using the following tional adjustment to basis. However, this as- excess. rules. signed basis is not reduced by any depletion or depreciation that would have been allowed Allocating a basis increase. Allocate 1) Allocate the basis first to unrealized or allowable if the partnership had previously any basis increase required in rule (2) above receivables and inventory items included chosen the optional adjustment. first to properties with unrealized appreciation in the distribution to the extent of the The choice must be made with the part- to the extent of the unrealized appreciation. partnership's adjusted basis in those ner's tax return for the year of the distribution (If the basis increase is less than the total items. If the partnership's adjusted basis if the distribution includes any property sub- unrealized appreciation, allocate it among in those items exceeds the allocable ject to depreciation, depletion, or amorti- those properties in proportion to their re- basis, allocate the basis among the zation. If the choice does not have to be made spective amounts of unrealized appreciation.) items in proportion to their adjusted for the distribution year, it must be made with Allocate any remaining basis increase among bases to the partnership. the return for the first year in which the basis all the properties in proportion to their re- 2) Allocate any remaining basis to other of the distributed property is pertinent in de- spective fair market values. distributed properties in proportion to termining the partner's income tax. their adjusted bases to the partnership. A partner choosing this special basis ad- Example. Julie's basis in her partnership justment must attach a statement to his or her interest is $55,000. In a distribution in liqui- Example 1. The adjusted basis of Ted's tax return that the partner chooses under dation of her entire interest, she receives partnership interest is $30,000. In complete section 732(d) of the Internal Revenue Code properties A and B, neither of which is in- liquidation of his interest, he receives $10,000 to adjust the basis of property received in a ventory or unrealized receivables. Property A in cash, his share of the inventory items hav- distribution. The statement must show the has an adjusted basis to the partnership of ing a basis to the partnership of $12,000, and computation of the special basis adjustment $5,000 and a fair market value of $40,000. two parcels of land having adjusted bases to for the property distributed and list the prop- Property B has an adjusted basis to the part- the partnership of $12,000 and $4,000. erties to which the adjustment has been allo- nership of $10,000 and a fair market value The basis of Ted's partnership interest is cated. of $10,000. reduced to $20,000 by the $10,000 cash. This To figure her basis in each property, Julie $20,000 basis is then divided among the Example. Bob purchased a 25% interest first assigns bases of $5,000 to property A properties he receives. The inventory items in X partnership for $17,000 cash. At the time and $10,000 to property B (their adjusted in his hands now have a basis of $12,000. of the purchase, the partnership owned in- bases to the partnership). This leaves a To divide the balance of $8,000, he first adds ventory having a basis to the partnership of $40,000 basis increase (the $55,000 the partnership's bases for the land ($12,000 $14,000 and a fair market value of $16,000. allocable basis minus the $15,000 total of the + $4,000 = $16,000). The bases of the two Thus, $4,000 of the $17,000 he paid was at- assigned bases). She first allocates $35,000 parcels of land in his hands are $6,000 tributable to his share of inventory with a ba- to property A (its unrealized appreciation). [(12,000 ÷ 16,000) × $8,000] and $2,000 sis to the partnership of $3,500. The remaining $5,000 is allocated between [(4,000 ÷ 16,000) × $8,000], respectively. Within 2 years after acquiring his interest, the properties based on their fair market val- Bob withdrew from the partnership and for his ues, $4,000 ($40,000/$50,000) to property A Example 2. Jenny's basis for her part- entire interest received cash of $1,500, in- and $1,000 ($10,000/$50,000) to property B. nership interest is $18,000. In a distribution ventory with a basis to the partnership of Julie's basis in property A is $44,000 ($5,000 in liquidation of her entire interest, she re- $3,500, and other property with a basis of + $35,000 + $4,000) and her basis in property ceives $12,000 cash, her share of inventory $6,000. The value of the inventory received B is $11,000 ($10,000 + $1,000). items having an adjusted basis to the part- was 25% of the value of all partnership in- Page 10 ventory. (It is immaterial whether the inven- 1) Performing services for or transferring by the partnership is $2,000 ($8,000 − tory he received was on hand when he ac- property to a partnership if— $6,000). Sandy's income from the partnership quired his interest.) is $8,000, and the remaining $12,000 will be Since the partnership from which Bob a) There is a related allocation and reported by the other partners in proportion withdrew did not make the optional adjust- distribution to a partner, and to their shares under the partnership agree- ment to basis, he chose to adjust the basis b) The entire transaction, when ment. of the inventory received. His share of the viewed together, is properly char- If the partnership net income had been partnership's basis for the inventory is in- acterized as occurring between the $30,000, there would have been no guaran- 1 creased by $500 ( /4 of the $2,000 difference partnership and a partner not acting teed payment since her share, without regard between the $16,000 fair market value of the in the capacity of a partner. to the guarantee, would have been greater inventory and its $14,000 basis to the part- than the guarantee. nership at the time he acquired his interest). 2) Transferring money or other property to The adjustment applies only for purposes of a partnership if— Self-employed health insurance premi- determining his new basis in the inventory, a) There is a related transfer of money ums. Premiums for health insurance paid by and not for purposes of partnership gain or a partnership on behalf of a partner for ser- loss on disposition. or other property by the partnership to the contributing partner or an- vices as a partner are treated as guaranteed The total to be allocated among the prop- payments. The partnership can deduct the erties Bob received in the distribution is other partner, and − payments as a business expense and the $15,500 ($17,000 basis of his interest b) The transfers together are properly partner must include them in gross income. $1,500 cash received). His basis in the in- characterized as a sale or ex- However, if the partnership accounts for in- ventory items is $4,000 ($3,500 partnership change of property. surance paid for a partner as a reduction in basis + $500 special adjustment). The re- distributions to the partner, the partnership maining $11,500 is allocated to his new basis cannot deduct the premiums. for the other property he received. Payments by accrual basis partnership to cash basis partner. A partnership that uses For 1997, a partner who qualifies can de- an accrual method of accounting cannot de- duct 40% of the health insurance premiums Mandatory adjustment. A partner does duct any business expense owed to a cash paid by the partnership on his or her behalf not always have a choice whether or not to basis partner until the amount is paid. How- as an adjustment to income. The partner use this special adjustment to basis. The ever, this rule does not apply to guaranteed cannot deduct the premiums for any calendar special adjustment to basis must be made for payments made to a partner, which are gen- month or part of a month in which the partner a distribution of property, whether or not the erally deductible when accrued. is eligible to participate in any subsidized distribution is made within 2 years after the health plan maintained by any employer of partnership interest was acquired, if all of the the partner or the partner's spouse. For more following conditions existed when the partner Guaranteed Payments information on the self-employed health in- received the partnership interest. surance deduction, see chapter 10 in Publi- Guaranteed payments are those made by a cation 535. 1) The fair market value of all partnership partnership to a partner that are determined property (other than money) was more without regard to the partnership's income. A Note. For 1998, a partner who qualifies than 110% of its adjusted basis to the partnership treats guaranteed payments for can deduct 45% of the health insurance pre- partnership. services, or for the use of capital, as if they miums paid on his or her behalf as an ad- were made to a person who is not a partner. justment to income. 2) If there had been a liquidation of the This treatment is for purposes of determining partner's interest immediately after it was gross income and deductible business ex- Including payments in partner's income. acquired, an allocation of the basis of penses only. For other tax purposes, guar- Guaranteed payments are included in income that interest under the general rules anteed payments are treated as a partner's in the partner's tax year in which the partner- (discussed earlier under Basis divided distributive share of ordinary income. Guar- ship's tax year ends. among properties) would have de- anteed payments are not subject to income tax withholding. creased the basis of property that could Example 1. Under the terms of a part- not be depreciated, depleted, or amor- The partnership generally deducts guar- anteed payments on line 10 of Form 1065 as nership agreement, Erica is entitled to a fixed tized and increased the basis of property annual payment of $10,000 without regard to that could be. a business expense. They are also listed on Schedules K and K–1 of the partnership re- the income of the partnership. Her distributive 3) The optional basis adjustment, if it had turn. The individual partner reports guaran- share of the partnership income is 10%. The been chosen by the partnership, would teed payments on Schedule E (Form 1040) partnership has $50,000 of ordinary income have changed the partner's basis for the as ordinary income, along with his or her after deducting the guaranteed payment. She property actually distributed. distributive share of the partnership's other must include ordinary income of $15,000 on ordinary income. her individual income tax return for her tax Guaranteed payments made to partners year in which the partnership's tax year ends Marketable securities. A partner's basis in ($10,000 guaranteed payment + $5,000 for organizing the partnership or syndicating × marketable securities received in a partner- interests in the partnership are capital ex- ($50,000 10%) distributive share). ship distribution, as determined in the pre- penses and are not deductible by the part- ceding discussions, is increased by any gain nership. However, these payments must be Example 2. Mike is a calendar year tax- recognized by treating the securities as included in the partners' individual income tax payer who is a partner in a partnership. The money. See Marketable securities treated as returns. See Organization expenses and partnership is on a fiscal year that ended money under Partner's Gain or Loss, earlier. syndication fees under Partnership Income January 31, 1997. Mike received guaranteed The basis increase is allocated among the or Loss, earlier. payments from the partnership from February securities in proportion to their respective 1, 1996, until December 31, 1996. He must amounts of unrealized appreciation before the include these guaranteed payments in in- basis increase. Minimum payment. If a partner is to receive come for 1997 and report them on his 1997 a minimum payment from the partnership, the income tax return. guaranteed payment is the amount by which the minimum payment is more than the part- Payments resulting in loss. If a part- ner's distributive share of the partnership in- nership agreement provides for guaranteed come before taking into account the guaran- payments to a partner and the payments re- Transactions Between teed payment. sult in a partnership loss in which the partner shares, the partner must: Partnership and Example. Under a partnership agree- Partners ment, Sandy is to receive 30% of the part- 1) Report the full amount of the guaranteed nership income, but not less than $8,000. The payments as ordinary income, and For certain transactions between a partner partnership has net income of $20,000. and his or her partnership, the partner is Sandy's share, without regard to the minimum 2) Separately take into account the appro- treated as not being a member of the part- guarantee, is $6,000 (30% × $20,000). The priate distributive share of the partner- nership. These transactions include: guaranteed payment that can be deducted ship loss. Page 11 attributing the interest to A. As a result, A is 3) A description of any facts that are rele- Sale or Exchange a more-than-50% partner. This means that vant in determining if the transfers are of Property any deduction for losses on transactions be- properly viewed as a disguised sale. Special rules apply to a sale or exchange of tween her and ABT will not be allowed, and (See section 1.707–3(b)(2) of the In- property between a partnership and certain gain from property that in the hands of the come Tax Regulations for a description persons. transferee is not a capital asset is treated as of the facts and circumstances that are ordinary, rather than capital, gain. considered in determining if the transfers Losses. Losses will not be allowed from a are a disguised sale.) sale or exchange of property (other than an More information. For more information on interest in the partnership) directly or indi- these special rules, see Sales and Exchanges Contribution to investment company. rectly between a partnership and a person Between Related Parties in chapter 2 of Gain is recognized when property is contrib- whose direct or indirect interest in the capital Publication 544. uted (in exchange for an interest in the part- or profits of the partnership is more than 50%. nership) to a partnership that would be If the sale or exchange is between two treated as an investment company if it were partnerships in which the same persons di- Contribution of Property incorporated. A loss realized on a contribution rectly or indirectly own more than 50% of the Usually, neither the partners nor the partner- of stock, securities, or other property to a capital or profits interests in each partnership, ship recognize a gain or loss when property partnership is not recognized. no deduction of a loss is allowed. is contributed to the partnership in exchange A partnership is treated as an investment The basis of each partner's interest in the for a partnership interest. This applies company if over 80% of the value of its as- partnership is decreased (but not below zero) whether a partnership is being formed or is sets, excluding cash and nonconvertible debt by the partner's share of the disallowed loss. already operating. The partnership's holding obligations, is held for investment and con- If the purchaser later sells the property, period for the property includes the partner's sists of readily marketable stocks, securities, only the gain realized greater than the loss holding period. or interests in regulated investment compa- not allowed will be taxable. If any gain from The contribution of limited partnership in- nies or real estate investment trusts. Whether the sale of the property is not recognized be- terests in one partnership for limited partner- a partnership is an investment company un- cause of this rule, the basis of each partner's ship interests in another partnership qualifies der this test is ordinarily determined imme- interest in the partnership is increased by the as a tax-free contribution of property to the diately after the transfer of property. partner's share of that gain. second partnership if the transaction is made These rules apply to limited partnerships for business purposes. The exchange is not and general partnerships, regardless of Gains. Gains are treated as ordinary income subject to the rules explained later under whether they are privately formed or publicly in a sale or exchange of property directly or Disposition of Partner's Interest. syndicated. indirectly between a person and a partner- ship, or between two partnerships, if both of Disguised sales. A contribution of money Basis of contributed property. If a partner the following apply: or other property to the partnership followed contributes property to a partnership, the by a distribution of different property from the partnership's basis for determining depreci- 1) More than 50% of the capital or profits partnership to the partner is treated not as a ation, depletion, and gain or loss for the interest in the partnership(s) is directly contribution and distribution, but as a sale of property is the same as the partner's adjusted or indirectly owned by the same property, if: basis for the property when it was contributed, person(s), and increased by any gain recognized by the 1) The distribution would not have been partner at the time of contribution. 2) The property in the hands of the made but for the contribution, and transferee immediately after the transfer is not a capital asset. Property that is not 2) The partner's right to the distribution Allocations to account for built-in gain or a capital asset includes accounts does not depend on the success of loss. The fair market value of property at the receivable, inventory, stock-in-trade, and partnership operations. time it is contributed may be different from the depreciable or real property used in a partner's adjusted basis. The partnership All facts and circumstances are consid- trade or business. must allocate among the partners any in- ered in determining if the contribution and come, deduction, gain, or loss on the property distribution are more properly characterized More than 50% ownership. To determine if in a manner that will account for the differ- as a sale. However, if the contribution and there is more than 50% ownership in part- ence. This rule also applies to contributions distribution occur within two years of each nership capital or profits, the following rules of accounts payable and other accrued but other, the transfers are presumed to be a sale apply. unpaid items of a cash basis partner. unless the facts clearly indicate that the The partnership can use different allo- transfers are not a sale. If the contribution and 1) An interest directly or indirectly owned cation methods for different items of contrib- distribution occur more than two years apart, by or for a corporation, partnership, es- uted property. A single reasonable method the transfers are presumed not to be a sale tate, or trust is considered to be owned must be consistently applied to each item, unless the facts clearly indicate that the proportionately by or for its shareholders, and the overall method or combination of transfers are a sale. partners, or beneficiaries. methods must be reasonable. See Regu- Form 8275 required. A partner must at- lations section 1.704–3 for allocation methods 2) An individual is considered to own the tach Form 8275 (or other statement) to his generally considered reasonable. interest directly or indirectly owned by or her return if the partner contributes prop- If the partnership sells contributed prop- or for the individual's family. For this rule, erty to a partnership and, within two years erty and recognizes gain or loss, built-in gain “family” includes only brothers, sisters, (before or after the contribution), the partner- or loss is allocated to the contributing partner. half-brothers, half-sisters, spouses, an- ship transfers money or other consideration If contributed property is subject to depreci- cestors, and lineal descendants. to the partner. For exceptions to this require- ation or other cost recovery, the allocation of ment, see section 1.707–3(c)(2) of the In- deductions for these items takes into account 3) If a person is considered to own an in- come Tax Regulations. built-in gain or loss on the property. However, terest using rule (1), that person (the A partnership must attach Form 8275 (or the total depreciation, depletion, gain, or loss “constructive owner”) is treated as if ac- other statement) to its return if it distributes allocated to partners cannot be more than the tually owning that interest when rules (1) property to a partner, and, within two years depreciation or depletion allowable to the and (2) are applied. However, if a person (before or after the distribution), the partner partnership or the gain or loss realized by the is considered to own an interest using transfers money or other consideration to the partnership. rule (2), that person is not treated as partnership. actually owning that interest in reapply- Form 8275 must include the following in- Example. Sara and Gail form an equal ing rule (2) to make another person the formation. constructive owner. partnership. Sara contributed $10,000 in cash 1) A caption identifying the statement as a to the partnership and Gail contributed Example. Individuals A and B and Trust disclosure under Internal Revenue Code depreciable property with a fair market value T are equal partners in Partnership ABT. A's section 707. of $10,000 and an adjusted basis of $4,000. husband, AH, is the sole beneficiary of Trust The partnership's basis for depreciation is T. Trust T's partnership interest will be attri- 2) A description of the transferred property limited to the adjusted basis of the property buted to AH only for the purpose of further or money, including its value. in Gail's hands, $4,000. Page 12 In effect, Sara purchased an undivided the property exceeded the property's fair Interest acquired by gift, etc. If a partner one-half interest in the depreciable property market value immediately before the acquires an interest in a partnership by gift, with her contribution of $10,000. Assuming contribution. inheritance, or under any circumstance other that the depreciation rate is 10% a year under than by a contribution of money or property the General Depreciation System (GDS), she 4) Substituted basis property. If the part- to the partnership, the partner's basis must would have been entitled to a depreciation nership disposes of any of the above be determined using the basis rules described deduction of $500 per year, based on her in- property in a nonrecognition transaction, in Publication 551. terest in the partnership. these rules apply if the recipient of the However, since the partnership is allowed property disposes of any substituted ba- only $400 per year of depreciation (10% of sis property resulting from the trans- Adjusted Basis $4,000), no more than $400 can be allocated action. The partner's basis is increased or decreased between the partners. The entire $400 must by the following items. be allocated to Sara. Contribution of Services Increases. The basis of an interest in a Distribution of contributed property to an- A partner can acquire an interest in partner- partnership is increased by the partner's: other partner. If a partner contributes prop- ship capital or profits as compensation for 1) Additional contributions to the partner- erty to a partnership and the partnership dis- services performed or to be performed. ship, including an increased share of or tributes the property to another partner within assumption of partnership liabilities. 5 years of the contribution, the contributing Capital interest. A capital interest is an in- partner must recognize gain or loss on the terest that would give the holder a share of 2) Distributive share of taxable and non- distribution. the proceeds if the partnership's assets were taxable partnership income. sold at fair market value and the proceeds A 7-year period applies to property were distributed in a complete liquidation of 3) Distributive share of the excess of the ! contributed after June 8, 1997, except the partnership. This determination generally deductions for depletion over the basis CAUTION property contributed under a written is made at the time of receipt of the partner- of the depletable property. binding contract: ship interest. The fair market value of such an interest received by a partner as compen- Decreases. The partner's basis is decreased 1) That was in effect on June 8, 1997, and sation for services must generally be included (but never below zero) by: at all times thereafter before the contri- in the partner's gross income in the first tax 1) The money (including a decreased share bution, and year in which the partner can transfer the in- of partnership liabilities or an assumption terest or the interest is not subject to a sub- of the partner's individual liabilities by the 2) That provides for the contribution of a stantial risk of forfeiture. The partnership in- partnership) and adjusted basis of prop- fixed amount of property. terest transferred as compensation for erty distributed to the partner by the services is subject to the rules discussed in partnership. The recognized gain or loss is the amount chapter 2 of Publication 535 under Payment the contributing partner would have recog- in Restricted Property. 2) The partner's distributive share of the nized, because of the difference between the The fair market value of an interest in partnership losses (including capital property's basis and its fair market value at partnership capital transferred to a partner as losses). the time of contribution, if the property had payment for services to the partnership is a been sold for its fair market value when it was guaranteed payment, discussed earlier. 3) The partner's distributive share of non- distributed. The character of the gain or loss deductible partnership expenses that are will be the same as the character that would not capital expenditures. have resulted if the partnership had sold the Profits interest. A profits interest is a part- 4) The partner's deduction for depletion for property to the distributee partner. Appropri- nership interest other than a capital interest. any partnership oil and gas wells, up to ate adjustments must be made to the ad- If a person receives a profits interest for pro- the proportionate share of the adjusted justed basis of the contributing partner's viding services to or for the benefit of a part- basis of the wells allocated to the part- partnership interest and to the adjusted basis nership in a partner capacity or in anticipation ner. of the property distributed to reflect the rec- of being a partner, the receipt of such an in- ognized gain or loss. terest is not a taxable event for the partner 5) The partner's share of any section 179 or the partnership. However, this does not expenses, even if the partner cannot apply in the following situations. Disposition of certain contributed prop- deduct the entire amount on his or her individual income tax return. erty. The following rules determine the 1) The profits interest relates to a substan- character of the partnership's gain or loss on tially certain and predictable stream of Partner's liabilities assumed by part- a later disposition of certain types of property. income from partnership assets, such as nership. If contributed property is subject to income from high-quality debt securities a debt or if a partner's liabilities are assumed 1) Unrealized receivables. For property or a high-quality net lease. by the partnership, the basis of that partner's that was an unrealized receivable in the interest is reduced (but not below zero) by the hands of the contributing partner, any 2) Within 2 years of receipt, the partner liability assumed by the other partners. This gain or loss on a disposition by the disposes of the profits interest. partner must reduce his or her basis because partnership is ordinary income or loss. 3) The profits interest is a limited partner- the assumption of the liability is treated as a Unrealized receivables are defined later ship interest in a publicly traded part- distribution of money to that partner. The under Payments for Unrealized Receiv- nership. other partners' assumption of the liability is ables and Inventory Items. When read- treated as a contribution by them of money ing the definition, substitute “partner” for to the partnership. See Effect of Partnership “partnership.” Liabilities, later. 2) Inventory items. For property that was an inventory item in the hands of the Basis of Partner's Example 1. John acquired a 20% interest contributing partner, a gain or loss on a in a partnership by contributing property that disposition by the partnership within 5 Interest had an adjusted basis to him of $8,000 and years after the contribution is ordinary a $4,000 mortgage. The partnership assumed income or loss. Inventory items are de- The basis of a partnership interest acquired payment of the mortgage. The basis of John's fined later in Payments for Unrealized by a contribution of property, including interest is: money, is the money a partner contributed Receivables and Inventory Items. Adjusted basis of contributed property ...... $8,000 plus the adjusted basis of any property he or 3) Capital loss property. For property that she contributed. If the partner must recognize Minus: Part of mortgage assumed by other × was a capital asset in the contributing gain as a result of the contribution, this gain partners (80% $4,000) ...... 3,200 partner's hands, any loss on a disposi- is included in the basis of his or her interest. Basis of John's partnership interest ...... $4,800 tion by the partnership within 5 years Any increase in a partner's individual liabilities after the contribution is a capital loss. because of an assumption of partnership li- Example 2. If, in the above example, the The capital loss is limited to the amount abilities is considered a contribution of money contributed property had a $12,000 mortgage, by which the partner's adjusted basis for to the partnership by the partner. the basis of John's partnership interest would Page 13 be zero. The $1,600 difference between the A partner's share of accrued but unpaid 12) For tax years beginning after August 5, mortgage assumed by the other partners, expenses or accounts payable of a cash ba- 1997, an executor and a beneficiary of $9,600 (80% × $12,000), and his basis of sis partnership are not included in the ad- an estate. $8,000 would be treated as capital gain from justed basis of the partner's interest in the 13) A partnership and a person owning, di- the sale or exchange of a partnership interest. partnership. rectly or indirectly, 80% or more of the However, this gain would not increase the capital or profits interest in the partner- basis of his partnership interest. Partner's basis increased. If a partner's ship. share of partnership liabilities increases, or a Book value of partner's interest. The ad- partner's individual liabilities increase be- 14) Two partnerships in which the same justed basis of a partner's interest is deter- cause he or she assumes partnership liabil- persons own, directly or indirectly, 80% mined without considering any amount shown ities, this increase is treated as a contribution or more of the capital or profits interests. in the partnership books as a capital, equity, of money by the partner to the partnership. or similar account. Property subject to a liability. If prop- erty contributed to a partnership by a partner Example. Sam contributes to his part- Partner's basis decreased. If a partner's or distributed by the partnership to a partner nership property that has an adjusted basis share of partnership liabilities decreases, or is subject to a liability, the transferee is of $400 and a fair market value of $1,000. a partner's individual liabilities decrease be- treated as having assumed the liability to the His partner contributes $1,000 cash. While cause the partnership assumes his or her in- extent it does not exceed the fair market value each partner has increased his capital ac- dividual liabilities, this decrease is treated as of the property. count by $1,000, which will be reflected in the a distribution of money to the partner by the partnership books, the adjusted basis of partnership. Partner's share of recourse liabilities. A Sam's interest is only $400 and the adjusted partnership liability is a recourse liability to the basis of his partner's interest is $1,000. Assumption of liability. A partner or related extent that any partner or related person has person is considered to assume a partnership an economic risk of loss for that liability. A When determined. The adjusted basis of a liability only to the extent that: partner's share of a recourse liability equals partner's partnership interest is ordinarily de- his or her economic risk of loss for that liabil- termined at the end of the partnership's tax 1) He or she is personally liable for it, and ity. A partner has an economic risk of loss if year. However, if there has been a sale or that partner or related person, defined earlier, 2) The creditor knows that the liability was exchange of all or part of the partner's interest would be obligated (whether by agreement assumed by the partner or a person re- or a liquidation of his or her entire interest in or law) to make a net payment to the creditor lated to the partner. The creditor must a partnership, the adjusted basis is deter- or a contribution to the partnership with re- also be able to demand payment from mined on the date of sale, exchange, or liq- spect to the liability if the partnership were the partner, and no other partner or uidation. constructively liquidated. A partner who is the person related to another partner may creditor for a liability that would otherwise be bear the economic risk of loss on that Alternative rule for figuring adjusted ba- a nonrecourse liability of the partnership has liability immediately after the assump- an economic risk of loss in that liability. sis. In certain cases, the adjusted basis of tion. a partnership interest can be figured by using Constructive liquidation. Generally, in the partner's share of the adjusted basis of a constructive liquidation, the following events Related person. A related person, for are treated as occurring at the same time. partnership property that would be distributed these purposes, includes: if the partnership terminated. 1) All partnership liabilities become payable This alternative rule can be used if either 1) An individual and his or her spouse, an- in full. of the following applies. cestors, and lineal descendants. 2) All of the partnership's assets have a 1) The circumstances are such that the 2) An individual and a corporation 80% or value of zero, except for property con- partner cannot practicably apply the more in value of the outstanding stock tributed to secure a liability. general basis rules. of which is owned, directly or indirectly, 3) All property is disposed of by the part- by or for such individual. 2) It is, in the opinion of the IRS, reason- nership in a fully taxable transaction for able to conclude that the result produced 3) Two corporations that are members of no consideration (except relief from li- will not vary substantially from the result the same controlled group. abilities for which the creditor's right to under the general basis rules. reimbursement is limited solely to one 4) A grantor and a fiduciary of any trust. or more assets of the partnership). Adjustments may be necessary in figuring the adjusted basis of a partnership interest 5) Fiduciaries of two separate trusts if the 4) All items of income, gain, loss, or de- under the alternative rule. For example, ad- same person is a grantor of both trusts. duction are allocated to the partners. justments would be required to include in the 6) A fiduciary and a beneficiary of the same 5) The partnership liquidates. partner's share of the adjusted basis of part- trust. nership property any significant discrepancies Example. Ted and Jane form a cash ba- that resulted from contributed property, 7) A fiduciary and a beneficiary of two sis general partnership with cash contribu- transfers of partnership interests, or distribu- separate trusts if the same person is a tions of $20,000 each. Under the partnership tions of property to the partners. grantor of both trusts. agreement, they share all partnership profits and losses equally. They borrow $60,000 and 8) A fiduciary of a trust and a corporation, purchase depreciable business equipment. Effect of Partnership 80% or more in value of the outstanding This debt is included in the partners' basis in stock of which is owned, directly or indi- the partnership because incurring it creates Liabilities rectly, by or for the trust or a grantor of an additional $60,000 of basis in the partner- A partner's basis in a partnership interest in- the trust. ship's depreciable property. cludes the partner's share of a partnership li- 9) A person and a tax-exempt educational If neither partner has an economic risk of ability only if, and to the extent that, the li- loss in the liability, it is a nonrecourse liability. ability: or charitable organization controlled di- rectly or indirectly by the person or by Each partner's basis would include his or her members of the person's family. share of the liability, $30,000. 1) Creates or increases the partnership's If Jane is required to pay the creditor if the basis in any of its assets, 10) A corporation and a partnership if the partnership defaults, she has an economic 2) Gives rise to a current deduction to the same persons own 80% or more in value risk of loss in the liability. Her basis in the partnership, or of the outstanding stock of the corpo- partnership would be $80,000 ($20,000 + ration and 80% or more of the capital or $60,000), while Ted's basis would be 3) Constitutes a nondeductible, noncapital profits interest in the partnership. $20,000. expense of the partnership. 11) Two S corporations or an S corporation Limited partner. A limited partner gen- The term “assets” in (1) above includes capi- and a C corporation if the same persons erally has no obligation to contribute addi- talized items allocable to future periods, such own 80% or more in value of the out- tional capital to the partnership and therefore as organization expenses. standing stock of each corporation. does not have an economic risk of loss in Page 14 partnership recourse liabilities. Thus, absent + $15,000 liability relief). He reports $5,000 Payments in liquidation of interest in some other factor, such as the guarantee of ($25,000 realized − $20,000 basis) as a cap- partnership property. Payments made in a partnership liability by the limited partner ital gain. liquidation of the interest of a retiring or de- or the limited partner making the loan to the ceased partner in exchange for his or her in- partnership, a limited partner generally does Example 2. The facts are the same as terest in partnership property are considered not have a share of partnership recourse li- Example 1, except that Fred withdraws from a distribution, not a distributive share or abilities. the partnership when the adjusted basis of guaranteed payment that could give rise to a his interest in the partnership is zero. He is deduction (or its equivalent) for the partner- Partner's share of nonrecourse liabilities. considered to have received a distribution of ship. A partnership liability is a nonrecourse liability $15,000, his relief of liability. He reports a Unrealized receivables and goodwill. if no partner or related person has an eco- capital gain of $15,000. Payments in exchange for an interest in nomic risk of loss for that liability. A partner's partnership property do not include amounts share of nonrecourse liabilities is generally Partnership election to adjust basis of paid for: proportionate to his or her share of partner- partnership property. Generally, a partner- ship profits. However, this rule may not apply ship's basis in its assets is not affected by a 1) Unrealized receivables of the partner- if the partnership has taken deductions at- transfer of an interest in the partnership, ship, or tributable to nonrecourse liabilities or the whether by sale or exchange or because of partnership holds property that was contrib- the death of a partner. However, the partner- 2) Goodwill of the partnership, except to the uted by a partner. See section 1.752–3 of the ship can elect to make an optional adjustment extent the partnership agreement pro- Income Tax Regulations for more information. to basis in the year of transfer. See Adjusting vides for a payment for goodwill. the Basis of Partnership Property, later, for More information. For more information on information on making the election. Unrealized receivables are defined in the effect of partnership liabilities, including Payments for Unrealized Receivables and rules for limited partners and examples, see Exchange of partnership interests. An ex- Inventory Items, later. However, for this pur- sections 1.752–1 through 1.752–5 of the In- change of partnership interests generally pose, unrealized receivables do not include come Tax Regulations. does not qualify as a nontaxable exchange the Other items treated as unrealized receiv- of like-kind property. This applies regardless ables listed in that discussion. of whether they are general or limited part- This rule about unrealized receivables and nership interests or interests in the same or goodwill of the partnership applies to partners Disposition of different partnerships. However, under certain retiring or dying on or after January 5, 1993 circumstances, such an exchange may be (unless a written contract to purchase the re- Partner's Interest treated as a tax-free contribution of property tiring partner's interest in the partnership was to a partnership. See Contribution of Property, binding on January 4, 1993, and at all times The following discussions explain the treat- earlier. thereafter), only if: ment of gain or loss from the disposition of An interest in a partnership that has a valid an interest in a partnership. election in effect under section 761(a) of the 1) Capital is not a material income- Internal Revenue Code to be excluded from producing factor for the partnership, and Abandoned or worthless partnership in- the partnership rules of the Code is treated terest. A loss incurred from the abandon- as an interest in each of the partnership as- 2) The retiring or deceased partner was a ment or worthlessness of a partnership inter- sets and not as a partnership interest. See general partner in the partnership. est is an ordinary loss only if: Exclusion From Partnership Rules, earlier. 1) The transaction is not a sale or ex- If the partner was not a general partner change, and Installment reporting for sale of partner- or if capital is a material income-producing ship interest. A partner who sells a partner- factor, the partnership will not receive a de- 2) The partner has not received an actual ship interest at a gain may be able to report duction or its equivalent (distributive share) or deemed distribution from the partner- the sale on the installment method. For re- for the payments. ship. quirements and other information on an in- Capital is not a material income-producing stallment sale, see Publication 537, Install- factor if substantially all the gross income of If the partner receives even a de minimis ac- ment Sales. the business consists of fees, commissions, tual or deemed distribution, the entire loss is The gain from the installment sale is or other compensation for personal services a capital loss. treated as part capital gain and part ordinary performed by a partner or the partnership's income if the partnership's assets included employees. The practice of his or her profes- Sale, Exchange, unrealized receivables and substantially ap- sion by a physician, dentist, lawyer, architect, preciated inventory items. See Payments for or accountant is treated as a trade or busi- or Other Transfer Unrealized Receivables and Inventory Items, ness in which capital is not a material The sale or exchange of a partner's interest later. income-producing factor. This rule applies in a partnership usually results in capital gain An allocation must be made to ensure that even though the practitioner may have a or loss. However, see Payments for Unreal- the income is correctly reported. The gain al- substantial capital investment in the profes- ized Receivables and Inventory Items, later, located to unrealized receivables and sub- sional equipment or physical plant of the for certain exceptions. Gain or loss is the dif- stantially appreciated inventory items is gen- practice, so long as the capital investment is ference between the amount realized and the erally ordinary income and must be reported merely incidental to the professional practice. adjusted basis of the partner's interest in the in the year of sale. The gain allocated to the Partners' valuation. Generally, the part- partnership. If the selling partner is relieved other assets is capital gain and can be re- ners' valuation of a partner's interest in part- of any partnership liabilities, that partner must ported under the installment method. nership property in an arm's-length agree- include the liability relief as part of the amount ment will be treated as correct. If the valuation realized for his or her interest. reflects only the partner's net interest in the Liquidation at Partner's property (total assets less liabilities), it must Example 1. Fred became a limited part- be adjusted so that both the value of and the ner in the ABC Partnership by contributing Retirement or Death basis for the partner's interest include the $10,000 in cash on the formation of the part- Payments made by the partnership to a retir- partner's share of partnership liabilities. nership. The adjusted basis of his partnership ing partner or successor in interest of a de- Gain or loss on distribution. Upon the interest at the end of the current year is ceased partner in return for the partner's en- receipt of the distribution, the retiring partner $20,000, which includes his $15,000 share tire interest in the partnership may have to or successor in interest of a deceased partner of partnership liabilities. The partnership has be allocated between payments in liquidation will recognize gain only to the extent that any no unrealized receivables or substantially of the partner's interest in partnership prop- money (and marketable securities treated as appreciated inventory items. Fred sells his erty and other payments. money) distributed is more than the partner's interest in the partnership for $10,000 in cash. For income tax purposes, a retiring partner adjusted basis in the partnership. The partner He had been paid his share of the partnership or successor in interest to a deceased partner will recognize a loss only if the distribution is income for the tax year. is treated as a partner until his or her interest in money, unrealized receivables, and inven- Fred realizes $25,000 from the sale of his in the partnership has been completely liqui- tory items. No loss is recognized if any other partnership interest ($10,000 cash payment dated. property is received. Page 15 Other payments. Payments made by the These rights must have arisen under a Inventory items that have appreciated partnership to a retiring partner or successor contract or agreement that existed at the time substantially in value. Inventory items of in interest of a deceased partner that are not of sale or distribution, even though the part- the partnership are considered to have ap- made in exchange for an interest in partner- nership may not be able to enforce payment preciated substantially in value if, at the time ship property are treated as distributive until a later date. For example, unrealized of the sale or distribution, their total fair mar- shares of partnership income or guaranteed receivables include accounts receivable of a ket value is more than 120% of the partner- payments. This rule applies regardless of the cash method partnership and rights to pay- ship's adjusted basis for the property. How- time over which the payments are to be ment for work or goods begun but incomplete ever, if a principal purpose for acquiring made. It applies to payments made for the at the time of the sale or distribution of the inventory property is to avoid ordinary income partner's share of unrealized receivables and partner's share. treatment by reducing the appreciation to less goodwill not treated as a distribution. The basis for any unrealized receivables than 120%, that property is excluded. If the amount is based on partnership in- includes all costs or expenses for the receiv- Items included as inventory. Inventory come, the payment is taxable as a distributive ables that were paid or accrued but not pre- items are not just stock-in-trade of the part- share of partnership income. The payment viously taken into account under the partner- nership. They include inventory on hand at retains the same character when reported by ship's method of accounting. the end of the tax year or held primarily for the recipient that it would have had if reported Other items treated as unrealized sale to customers in the normal course of by the partnership. For more information, see receivables. Unrealized receivables include business. They include any asset which, if Partner's Distributive Share, earlier, and Dis- potential gain that would be ordinary income sold or exchanged by the partnership, would tributive Share in Year of Disposition, later. if the following partnership property were sold not be a capital asset or section 1231 prop- If the amount is not based on partnership at its fair market value on the date of the erty (real or depreciable business property income, it is treated as a guaranteed pay- payment. held more than one year). For example, ac- ment. The recipient reports guaranteed pay- counts receivable acquired for services or ments as ordinary income. For additional in- 1) Mining property for which exploration from the sale of inventory and unrealized formation on guaranteed payments, see expenses were deducted. receivables are inventory items. Inventory Transactions Between Partnership and Part- items also include any other property held by ners, earlier. 2) Stock in a Domestic International Sales the partnership that would be considered in- These payments are included in income Corporation (DISC). ventory if held by the selling or distributee by the recipient for his or her tax year that 3) Certain farm land for which expenses for partner. includes the end of the partnership tax year soil and water conservation or land Example. Assume that you sold your for which the payments are a distributive clearing were deducted. share or in which the partnership is entitled one-third interest in your partnership on to deduct them as guaranteed payments. 4) Franchises, trademarks, or trade names. March 20, 1997. The partnership used an Former partners who continue to make accrual method of accounting, had no liabil- guaranteed periodic payments to satisfy the 5) Oil, gas, or geothermal property for ities, and had the following assets: partnership's liability to a retired partner after which intangible drilling and develop- ment costs were deducted. Fair the partnership is terminated can deduct the Adjusted Market payments as a business expense in the year 6) Stock of certain controlled foreign cor- Assets Basis Value paid. porations. Cash ...... $10,000 $10,000 Accounts receivable ...... 5,000 2,500 7) Market discount bonds and short-term Trade notes receivable ...... 2,000 2,100 Payments for Unrealized obligations. Merchandise on hand ...... 4,000 9,500 Land ...... 80,000 100,000 Receivables and Inventory 8) Property subject to recapture of depre- Total assets ...... $101,000 $124,100 ciation under sections 1245 and 1250 Items of the Internal Revenue Code. Depreci- The inventory items—the accounts If a partner receives money or property in ation recapture is discussed in chapter receivable, trade notes receivable, and exchange for any part of a partnership inter- 4 of Publication 544. est, the amount due to his or her share of the merchandise—had a total adjusted basis of $11,000 and a fair market value of $14,100. partnership's unrealized receivables or sub- Determining value. Generally, any The total value of all assets other than cash stantially appreciated inventory items results arm's-length agreement between the buyer was $114,100. Because the fair market value in ordinary income or loss. This amount is and the seller (or between the partnership of the inventory items ($14,100) was more treated as if it were received for the sale or and the partner receiving the distribution) will than 120% of their adjusted basis ($11,000), exchange of property that is not a capital as- establish the amount or value of: set. the partnership had substantially appreciated inventory items. The amount you received for This treatment applies to the unrealized 1) The sales price of unrealized receiv- your interest in the inventory items that ex- receivables part of payments to a retiring ables, or partner or successor in interest of a deceased ceeded your basis in them is ordinary income. partner only if that part is not treated as paid 2) The value of the receivables received in in exchange for partnership property. See a distribution treated as a sale or ex- Notification of partnership. If a partner ex- Payments in liquidation of interest in partner- change. changes a partnership interest attributable to ship property earlier. unrealized receivables or inventory (substan- If no agreement exists, an allowance must tially appreciated inventory if the exchange For a sale or exchange of a partner- be made for the estimated cost to complete was before August 6, 1997) for money or ! ship interest after August 5, 1997, it performance of the contract or agreement, property, he or she must notify the partner- CAUTION is no longer necessary that inventory and for the time between the sale or distribu- ship in writing. This must be done within 30 be substantially appreciated before it gener- tion and the time of payment. days of the transaction or, if earlier, by Janu- ates ordinary income (rather than capital ary 15 of the calendar year following the cal- gain). However, this does not apply to any Example. You are a partner in ABC endar year of the exchange. A partner may sale or exchange under a written contract that Partnership. The adjusted basis of your part- be subject to a $50 penalty for each failure to is in effect on June 8, 1997, and at all times nership interest at the end of the current year notify the partnership about such a trans- thereafter before the sale or exchange. is zero. Your share of potential ordinary in- action, unless the failure was due to reason- come from partnership depreciable property able cause and not willful neglect. Unrealized receivables. Unrealized receiv- is $5,000. The partnership has no other un- ables are any rights to payment not already realized receivables or inventory items. You Information return required of partnership. included in income for: sell your interest in the partnership for When a partnership is notified of an exchange $10,000 in cash and you report the entire of partnership interests involving unrealized 1) Goods delivered or to be delivered to the amount as a gain since your adjusted basis receivables or inventory items, the partner- extent the payment would be treated as in the partnership is zero. You report as ordi- ship must file Form 8308, Report of a Sale received for property other than a capital nary income your $5,000 share of potential or Exchange of Certain Partnership Interests. asset, or ordinary income from the partnership's Form 8308 is filed with Form 1065 for the tax depreciable property. The remaining $5,000 year that includes the last day of the calendar 2) Services rendered or to be rendered. gain is a capital gain. year in which the exchange took place. If no- Page 16 tified of an exchange after filing Form 1065, for more than 5 years, her gain would have items on a daily basis. That daily portion is the partnership must file Form 8308 sepa- been capital gain, provided the inventory was then allocated to the partners in proportion to rately, within 30 days of the notification. a capital asset in her hands at the time of their interests in the partnership at the close On Form 8308, the partnership states the sale. of each day. This rule applies to the following date of the exchange and the names, ad- items for which the partnership uses the cash dresses, and taxpayer identification numbers Example 2. Mike, a distributee partner, method of accounting. of the partnership filing the return and the received his share of accounts receivable transferee and transferor in the exchange. when his law firm dissolved. The partnership 1) Interest. The partnership must also provide a copy of used the cash method of accounting, so the Form 8308 (or a written statement with the receivables had a basis of zero to Mike. If the 2) Taxes. receivables are later collected, or if Mike sells same information) to each transferee and 3) Payments for services or for the use of them, the amount received will be ordinary transferor by the later of January 31 following property. the end of the calendar year or 30 days after income. The 5-year rule, illustrated in Exam- it receives notice of the exchange. ple 1, does not apply to accounts receivable. The partnership may be subject to a pen- Deceased partner. If a partner dies, the alty of up to $50 for each failure to timely file Substituted basis property. If a partner's estate or other successor in interest Form 8308 and a $50 penalty for each failure distributee partner disposes of unrealized reports on its return the decedent's distribu- to furnish a copy of Form 8308 to a transferor receivables or inventory items in a nonrecog- tive share of the partnership items for the or transferee, unless the failure is due to nition transaction, ordinary gain or loss treat- partnership year ending after the death oc- reasonable cause and not willful neglect. If ment applies to a later disposition of any curred. the failure is intentional, a higher penalty may substituted basis property resulting from the For example, if the partnership and the be imposed. See the form instructions for transaction. partners all use the calendar year as their tax details. year and one of the partners dies on June 10, none of the income of the partnership for that Distributive Share in Year year will be reported on the final return of the Statement required of partner. If a partner deceased partner. All of it will be included on sells or exchanges any part of an interest in of Disposition the return of the partner's estate or other a partnership having unrealized receivables If a partner disposes of his or her entire in- successor in interest. or inventory (substantially appreciated inven- terest in a partnership, the partner must in- However, if the partnership terminates tory if the sale or exchange was before Au- clude his or her distributive share of partner- with the death of a partner, the partnership gust 6, 1997), he or she must file a statement ship items in income for the tax year in which year closes for all partners. The deceased with his or her tax return for the year in which membership in the partnership ends. To partner's share of income for that year will be the sale or exchange occurs. The statement compute the distributive share of these items, included in the deceased partner's final re- must contain the following information. the partnership's tax year is considered turn. If the decedent's tax year is different ended on the date the partner disposed of the 1) The date of the sale or exchange, the from the partnership's, the decedent's final interest. To avoid an interim closing of the return will include his or her share of part- partner's adjusted basis for the partner- partnership books, the partners can agree to ship interest, and the part of the basis nership items for the partnership year ending estimate the distributive share by taking the with the decedent's death and any partner- that represents the unrealized receiv- prorated amount the partner would have in- ables or inventory items. ship year ending earlier in the decedent's last cluded in income if he or she had remained tax year. 2) The money and fair market value of any a partner for the entire partnership tax year. other property the partner received or A partner who sells or exchanges only part For partnership years beginning after will receive for the interest in the part- of an interest in a partnership, or whose in- ! 1997, the partnership's tax year nership, and the part for the unrealized terest is reduced (whether by entry of a new CAUTION closes with respect to a partner receivables or inventory items. partner, partial liquidation of a partner's inter- whose entire interest terminates by death. est, gift, or otherwise), reports his or her dis- The decedent's distributive share of the part- 3) The statement described earlier in Spe- tributive share of partnership items by taking nership items for the partnership year in cial adjustment to basis of property re- into account his or her varying interests dur- which the death occurred are reported on the ceived under Partner's Basis for Distrib- ing the partnership year. decedent's final return. The distributive share uted Property, if the partner computes is figured as if for a partner who otherwise the basis for the unrealized receivables Example. ABC is a calendar year part- disposes of his or her entire interest in a or inventory items under that provision. nership with three partners, Alan, Bob, and partnership, as described at the beginning of 4) If the partnership used the optional basis Cathy. Under the partnership agreement, this discussion. adjustment, the computation described profits and losses are shared in proportion to Self-employment income. A different later under Adjusting the Basis of Part- each partner's contributions. On January 1 rule applies in computing a deceased part- nership Property and a list of the part- the ratio was 90% for Alan, 5% for Bob, and ner's self-employment income. Self- nership properties to which the adjust- 5% for Cathy. On December 1 Bob and Cathy employment income of a partner includes the ment has been allocated. each contributed additional amounts. The partner's distributive share of income earned new profit and loss sharing ratios were 30% by the partnership through the end of the for Alan, 35% for Bob, and 35% for Cathy. Partner's disposition of distributed unre- month in which the partner's death occurs. For its tax year ended December 31, the alized receivables or inventory items. In This is true even though the deceased part- partnership had a loss of $1,200. This loss general, any gain or loss on a sale or ex- ner's estate or heirs may succeed to the de- occurred equally over the partnership's tax change of unrealized receivables or inventory cedent's rights in the partnership. For this year. The loss is divided among the partners items a partner receives in a distribution is purpose, partnership income for the year in as follows: an ordinary gain or loss. For this purpose, which a partner dies is considered to be inventory items do not include real or depre- Profit Part earned equally in each month. ciable business property, even if they are not or Loss of Year Total Share held more than 1 year. Partner % × Held × Loss = of Loss Example. Larry, a partner in WoodsPar, is a calendar year taxpayer. WoodsPar's fis- Exception for inventory items held Alan ...... 90 × 11/12 × $1,200 = $990 more than 5 years. If a distributee partner 30 × 1/12 × 1,200 = 30 cal year ends June 30. For the partnership sells inventory items held for more than 5 year ending June 30, 1997, Larry's distribu- years after the distribution, the type of gain Bob ...... 5 × 11/12 × 1,200 = 55 tive share of partnership profits is $2,000. On × × or loss depends on how they are being used 35 1/12 1,200 = 35 August 18, 1997, Larry dies. For the partner- on the date sold. The gain or loss is capital × × ship year ending June 30, 1998, Larry and Cathy ...... 5 11/12 1,200 = 55 his estate's distributive share is $3,000. gain or loss if the property is a capital asset 35 × 1/12 × 1,200 = 35 in the partner's hands at the time sold. Larry's self-employment income to be re- ported on Schedule SE (Form 1040) for 1997 Example 1. Ann receives, through dis- Certain cash basis items prorated daily. is $2,500. This consists of his $2,000 distrib- solution, inventory that has a basis of If any partner's interest in a partnership utive share for the partnership tax year ending $19,000. Within 5 years, she sells the inven- changes during the tax year, each partner's June 30, 1997, plus $500 (2/12 × $3,000) of the tory for $24,000. The $5,000 gain is taxed as share of certain cash basis items of the part- distributive share for the tax year ending June ordinary income. If she had held the inventory nership must be determined by prorating the 30, 1998. Page 17 However, Larry's partnership income to partnership tax year during which Alan re- be reported on Form 1040 for 1997 is $2,000. cognizes gain with respect to the payments. This is because his final return includes only Form 1065 his share of partnership income for the part- Transfers. When there is a transfer of a nership year that ended within his last tax partnership interest because of a sale or ex- Example year. change or a partner's death, the partnership This filled-in Form 1065 is for the AbleBaker makes the optional adjustment by: Book Store, a partnership composed of Frank Able and Susan Baker. The partnership uses 1) Increasing the adjusted basis of the an accrual method of accounting and a cal- partnership property by the excess of: endar year for reporting income and loss. Frank works full time in the business, while a) The transferee's basis for his or her Adjusting the Basis of Susan works approximately 25% of her time partnership interest, over Partnership Property in it. Both partners are general partners. b) The transferee's share of the ad- The partnership agreement states that Generally, a partnership cannot adjust the justed basis of all partnership prop- Frank will receive a yearly guaranteed pay- basis of its property because of a distribution erty, or ment of $20,000 and Susan will receive of property to a partner or because of a $5,000. Any profit or loss will be shared transfer of an interest in the partnership, 2) Decreasing the adjusted basis of part- equally by the partners. The partners are whether by sale or exchange or because of nership property by the excess of: personally liable for all partnership liabilities. the death of a partner. The partnership can Both partners materially participate in the op- a) The transferee partner's share of adjust the basis only if it files an election to eration of the business. the adjusted basis of all partnership make an optional adjustment to the basis of In addition to income and expenses from property, over its property upon the distribution or transfer. partnership operations, AbleBaker made a A partnership does not adjust the basis of b) The transferee's basis for his or her $650 cash charitable contribution, received partnership property for a contribution of partnership interest. $150 from dividends, and received $50 tax- property, including money, to the partnership. exempt interest from municipal bonds. These adjustments affect the basis of Each partner's distributive share of spe- partnership property for the transferee partner cially allocated items should be shown on the Distributions. When there is a distribution appropriate line of the partner's Schedule K–1 of partnership property to a partner, the part- only. They become part of his or her share of the common partnership basis. and the total amount on Schedule K, instead nership makes the optional adjustment by: of on page 1, Form 1065, or Schedule A or D. Making the election. The optional adjust- 1) Increasing the adjusted basis of the re- Frank completes the partnership's Form ment to basis is made by filing a written tained partnership property by: 1065 as explained next. statement with Form 1065 for the tax year in a) Any gain recognized by the which the distribution or transfer occurs. For distributee partner on the distribu- the election to be valid, the return must be tion, plus filed on time, including extensions. The Page 1 statement must include the name and ad- b) The excess, if any, of the partner- dress of the partnership, be signed by one of The IRS sent Frank a postcard with his pre- ship's adjusted basis for the distrib- the partners, and state that the partnership addressed label asking if he needed a Form uted property (immediately before elects under section 754 to apply sections 1065 package. He returned the postcard and the distribution) over the basis of 734(b) and 743(b) of the Internal Revenue the IRS sent him the package. When Frank the property to the distributee, or Code. Once a valid election has been made, completes the return, he places the label in it applies in succeeding years until it is re- the address area on page 1. 2) Decreasing the adjusted basis of the re- voked. Frank supplies all the information re- tained partnership property by: If the election cannot be made with the quested at the top of the page. a) Any loss recognized by the return, a partner or the partnership can re- distributee partner on the distribu- quest an automatic extension of 12 months tion, plus to make the election. See section Income 301.9100–1T through 301.9100–3T of the The partnership's ordinary income (loss) from Temporary Procedure and Administration b) The excess, if any, of the distributee the trade or business activity is shown on Regulations for more information. partner's basis for the distributed lines 1a through 8. property over the partnership's ad- Line 1. Gross sales of $409,465 are en- justed basis for the property (im- Revoking the election. The election can be tered on line 1a. Returns and allowances of mediately before the distribution). revoked only with the approval of the IRS. An $3,365 are entered on line 1b, resulting in net application to revoke the election must be sales of $406,100, entered on line 1c. Timing of adjustment. If a partnership filed with the director for the district in which Line 2. Cost of goods sold, $267,641, completely liquidates the interest of a partner the partnership return must be filed. This ap- from Schedule A, line 8, is entered here. by making a series of cash payments treated plication must be filed within 30 days after the Line 3. Gross profit of $138,459 is shown as distributions of the partner's interest in close of the partnership tax year for which the on this line. partnership property, the basis adjustments change is to be effective. The application Line 7. Interest income on accounts to partnership property must correspond in must be signed by one of the partners and receivable, $559, is entered on this line. The timing and amount with the recognition of gain state why the partnership wishes to revoke schedule that must be attached for this line or loss by the retiring partner, or a deceased the election. is not shown. partner's successor in interest, with respect Examples of sufficient grounds for ap- Line 8. Total income, $139,018 (lines 3 to those payments. proving the application include: through 7), is shown on line 8. Example. Alan owns a one-third interest 1) A change in the nature of the business. in the partnership Sylvan Associates. Sylvan has an optional adjustment to basis election 2) A substantial increase in assets. Deductions in effect. When Alan retires, Sylvan continues 3) A change in the character of the assets. The partnership's allowable deductions are without dissolution and agrees to liquidate shown on lines 9 through 21. Alan's one-third interest in the partnership 4) An increased frequency of retirements Line 9. All salaries and wages are in- property by making a series of cash payments or shifts of partnership interests. cluded on line 9, except guaranteed pay- to Alan that are treated as distributions. The ments to partners (shown on line 10). Frank total amount of payments Alan will receive is However, the IRS will not approve an ap- lists $29,350 on line 9. The partnership had fixed and exceeds the adjusted basis of plication to revoke the election if its primary no employment credits to reduce that amount. Alan's interest in the partnership. purpose is to avoid decreasing the basis of Line 10. Guaranteed payments of Sylvan increases the adjusted basis of its partnership assets upon a transfer or distri- $25,000 to partners Frank ($20,000) and property by Alan's recognized gain in each bution. Susan ($5,000) are entered here. Page 18 Line 11. Repairs of $1,125 made to Line 1. As of January 1, the total of the partnership equipment are entered on this Pages 3 – 4 partners' capital accounts was $27,550 line. Schedule K (Frank — $14,050; Susan — $13,500). This Line 12. During the year, $250 owed to Schedule K lists the total of all partners' amount should agree with the beginning bal- the partnership was determined to be a wholly shares of income, deductions, credits, etc. ance shown on line 21 of Schedule L for the worthless business bad debt. The $250 is Each partner's distributive share of income, partners' capital accounts. shown on line 12. If this had been a non- deductions, credits, etc., is reported on Line 3. This is the net income per books. business bad debt, it would be included in the Schedule K–1. The line items for Schedule K Line 5. This is the total of lines 1 through partnership's separately stated short-term are discussed in combination with the 4. capital loss. Schedule K–1 line items, later. Line 6. Each partner withdrew $26,440 Line 13. Rent paid for the business (totaling $52,880) from the partnership. These premises, $20,000, is listed on this line. withdrawals are shown here and on Schedule Line 14. Deductible taxes of $3,295 are Page 4—Analysis of Net Income K, line 22. The partners' guaranteed pay- entered on this line. (Loss) ments, which were actually paid, are not in- Line 15. Interest paid to suppliers during An analysis must be made of the distributive cluded because they were deducted when the year totaled $1,451. This is business in- items on Schedule K. This analysis is based figuring the amount shown on line 3. terest, so it is entered on line 15. Interest paid on the type of partner. Since the AbleBaker Line 9. This shows the total equity of all to a partner that is not a guaranteed payment Book Store has two individual partners, both partners as shown in the books of record as is also included on this line. of whom are “active” general partners, the of December 31. This amount should agree Lines 16a and 16c. Depreciation of total, $73,870, on line 1 is entered on line 2a, with the year-end balance shown on line 21 $1,174 claimed on assets used in a trade or column ii. of Schedule L for the partners' capital ac- business is entered on these lines. Line 16b counts. is for depreciation listed elsewhere on the Item J on Schedule K–1 reflects each return. Form 4562 is not shown in this exam- Page 4 partner's share of the amounts shown on lines ple. 1 through 9 of Schedule M–2. Line 20. Other allowable deductions of Schedules L, M–1, and M–2 $8,003 not listed elsewhere on the return and Partnerships do not have to complete for which a separate line is not provided on Schedules L, M–1, or M–2 if all of the tests Schedule K–1 page 1 are included on this line. Frank at- listed under question 5 of Schedule B are met Schedule K–1 lists each partner's share of taches a schedule that lists each deduction and question 5 is marked “Yes.” The income, deductions, credits, etc. It also shows and the amount included on line 20. This AbleBaker Book Store does not meet all of where to report the items on the partner's in- schedule is not shown. the tests, so these schedules must be com- dividual income tax return. Illustrated is a Line 21. The total of all deductions, pleted. copy of the Schedule K–1 for Frank W. Able. $89,648 (lines 9 through 20), is entered on All information asked for at the top of Sched- this line. Schedule L ule K–1 must be supplied for each partner. Line 22. The amount on line 21 is sub- tracted from the amount on line 8. The result, Schedule L contains the partnership's bal- $49,370, is entered on line 22 of page 1 and ance sheets at the beginning and end of the Allocation of on line 1 of Schedule K. The amount allocated tax year. All information shown on the bal- ance sheets for the AbleBaker Book Store Partnership Items to each partner is listed on line 1 of Schedule The partners' shares of income, deductions, K–1. should agree with its books of record. The entry in column (d) of line 14 for total etc., are shown next. assets at the end of the year, $45,391, is Signatures carried to item F at the top of page 1 since the Income (Loss) answer to question 5 on Schedule B was Line 1. This line on Schedule K–1 shows Frank signs the return as a general partner. “No.” Frank's share ($24,685) of the income from The AbleBaker Book Store did not have a the partnership shown on Form 1065, page paid preparer. Schedule M–1 1, line 22. The total amount of income to both Schedule M–1 is the reconciliation of income partners is shown on line 1, Schedule K. per the partnership books with income per Line 4b. Dividends must be separately Page 2 Form 1065. stated. They are not included in the income Schedule A Line 1. This line shows the net income (loss) of the partnership on Form 1065, page per books of $48,920. This amount is from the 1, line 22. This line on Schedule K–1 shows Schedule A shows the computation of cost profit and loss account (not shown in this ex- Frank's share, $75. This line on Schedule K of goods sold. Beginning inventory, $18,125, ample). shows the total dividends of $150. is entered on line 1 and net purchases, Line 3. This line shows the guaranteed Line 5. This line on Schedule K–1 shows $268,741, are entered on line 2. The total, payments to partners. only the guaranteed payments to Frank of $286,866, is entered on line 6. Ending in- Line 5. This is the total of lines 1 through $20,000. This line on Schedule K shows the ventory, $19,225 (entered on line 7), is sub- 4 of $73,920. total guaranteed payments to both partners tracted from line 6 to arrive at cost of goods Line 6. Included in line 6 is the $50 tax- of $25,000. sold, $267,641 (entered on line 8 and on page exempt interest income from municipal bonds 1, line 2). recorded on the books but not included on Deductions Frank answers all applicable questions for Schedule K, lines 1 through 7. This interest Line 8. During the year, the partnership item 9. is reported on Schedule K, line 19. made a $650 cash contribution to the Ameri- Line 9. This is line 5 less line 8, $73,870. can Lung Association. Each partner may be This line is the same as line 1 of the Analysis able to deduct his or her share of the part- Schedule B of Net Income (Loss) section of Schedule K nership's charitable contribution on his or her at the top of page 4. individual income tax return if the partner Schedule B contains 11 questions about the itemizes deductions. Frank's share of the partnership. Frank answers question 1 by Schedule M–2 contribution, $325, is entered on line 8, marking the “General partnership” box. He Schedule K–1. This line on Schedule K shows answers questions 2 through 11 by marking Schedule M–2 is an analysis of the partners' the total contribution. the “No” boxes. capital accounts. It shows the total equity of Question 5 asks if the partnership meets all partners at the beginning and end of the all the requirements listed in items 5a, b, and tax year and the adjustments that caused any Investment Interest c. Because the partnership's total receipts increase or decrease. The total of all the Lines 14a–14b. The partnership had in- were not less than $250,000, all three of partners' capital accounts is the difference vestment income (dividends) of $150 as these requirements are not met. Frank must between the partnership's assets and liabil- shown on line 4b, Schedule K. This amount complete Schedules L, M–1, M–2, and item ities shown on Schedule L. A partner's capital is shown on line 14b(1), Schedule K, and the F on page 1 of Form 1065 and item J on account does not necessarily represent the partner's share is shown on line 14b(1), Schedule K–1. tax basis for an interest in the partnership. Schedule K–1. Page 19 Net Earnings From partner's share is shown on his or her enters the $50 municipal bond interest re- Schedule K–1. Each partner uses his or her ceived by the partnership on Schedule K and Self-Employment share to figure his or her self-employment tax $25 on each partner's Schedule K–1. Line 15a. Net earnings (loss) from self- on Schedule SE (Form 1040), Self- employment are figured using the worksheet Employment Tax (not shown). in the Form 1065 instructions for Schedule K (not shown). Frank and Susan's net earnings Distributions from self-employment are the total of the Tax-Exempt Interest Income Line 22. Frank enters the $52,880 cash partnership income shown on line 1 of Line 19. Tax-exempt interest income, in- withdrawals made by the partners during the Schedule K and the guaranteed payments cluding any exempt-interest dividends re- year on Schedule K. He enters the amount shown on line 5. This total, $74,370, is en- ceived from a mutual fund or other regulated each partner withdrew on the partner's tered on Schedule K, and each individual investment company, is entered here. Frank Schedule K–1.

Page 20 U.S. Partnership Return of Income OMB No. 1545-0099 Form 1065 Department of the Treasury For calendar year 1997, or tax year beginning , 1997, and ending , 19 . Internal Revenue Service ᮣ See separate instructions. 1997 D Employer identification number A Principal business activity Use the Retail IRS B Principal product or service label. 10-9876543 DEC97 I E Date business started Other- AbleBaker Book Store Books wise, R 10-1-79 please 334 West Main Street C Business code number S F Total assets print Orange, MD 20904 (see page 10 of the instructions) or type. 5942 $ 45,391

G Check applicable boxes: (1) Initial return (2) Final return (3) Change in address (4) Amended return H Check accounting method: (1) Cash (2) ߛ Accrual (3) Other (specify) ᮣ I Number of Schedules K-1. Attach one for each person who was a partner at any time during the tax year ᮣ 2

Caution: Include only trade or business income and expenses on lines 1a through 22 below. See the instructions for more information.

1a Gross receipts or sales 1a 409,465 b Less returns and allowances 1b 3,365 1c 406,100

2 Cost of goods sold (Schedule A, line 8) 2 267,641 3 Gross profit. Subtract line 2 from line 1c 3 138,459 4 Ordinary income (loss) from other partnerships, estates, and trusts (attach schedule) 4 5 Income 5 Net farm profit (loss) (attach Schedule F (Form 1040)) 6 Net gain (loss) from Form 4797, Part II, line 18 6

7 Other income (loss) (attach schedule) 7 559

8 Total income (loss). Combine lines 3 through 7 8 139,018

9 Salaries and wages (other than to partners) (less employment credits) 9 29,350 10 Guaranteed payments to partners 10 25,000 11 Repairs and maintenance 11 1,125 12 Bad debts 12 250 13 Rent 13 20,000 14 Taxes and licenses 14 3,295 15 Interest 15 1,451 16a Depreciation (if required, attach Form 4562) 16a 1,174 b Less depreciation reported on Schedule A and elsewhere on return 16b –0– 16c 1,174 17 Depletion (Do not deduct oil and gas depletion.) 17 18 18 (see page 11 of the instructions for limitations) Retirement plans, etc. 19 Employee benefit programs 19

20 Other deductions (attach schedule) 20 8,003

Deductions 21 Total deductions. Add the amounts shown in the far right column for lines 9 through 20 21 89,648

22 Ordinary income (loss) from trade or business activities. Subtract line 21 from line 8 22 49,370 Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than general partner or limited liability company member) is based on all Please information of which preparer has any knowledge. Sign Frank W. Able 3-12-98 Here ᮣ Signature of general partner or limited liability company member ᮣ Date Preparer’s Date Preparer’s social security no. signature Check if Paid ᮣ self-employed ᮣ Preparer’s Firm’s name (or EIN ᮣ Use Only yours if self-employed) and address ᮣ ZIP code ᮣ

For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 11390Z Form 1065 (1997)

Page 21 Form 1065 (1997) Page 2 Schedule A Cost of Goods Sold (see page 13 of the instructions)

1 Inventory at beginning of year 1 18,125 2 Purchases less cost of items withdrawn for personal use 2 268,741 3 Cost of labor 3 – 0 – 4 Additional section 263A costs (attach schedule) 4 – 0 – 5 Other costs (attach schedule) 5 – 0 – 6 Total. Add lines 1 through 5 6 286,866 7 Inventory at end of year 7 19,225 8 Cost of goods sold. Subtract line 7 from line 6. Enter here and on page 1, line 2 8 267,641 9a Check all methods used for valuing closing inventory: (i) Cost as described in Regulations section 1.471-3 (ii) ߛ Lower of cost or market as described in Regulations section 1.471-4 (iii) Other (specify method used and attach explanation) ᮣ b Check this box if there was a writedown of “subnormal” goods as described in Regulations section 1.471-2(c) ᮣ c Check this box if the LIFO inventory method was adopted this tax year for any goods (if checked, attach Form 970) ᮣ d Do the rules of section 263A (for property produced or acquired for resale) apply to the partnership? Yes ߛ No e Was there any change in determining quantities, cost, or valuations between opening and closing inventory? Yes ߛ No If “Yes,” attach explanation.

Schedule B Other Information

1 What type of entity is filing this return? Check the applicable box: Yes No a ߛ General partnership b Limited partnership c Limited liability company d Other (see page 14 of the instructions) ᮣ ߛ 2 Are any partners in this partnership also partnerships? 3 Is this partnership a partner in another partnership? ߛ 4 Is this partnership subject to the consolidated audit procedures of sections 6221 through 6233? If “Yes,” see ߛ Designation of Tax Matters Partner below 5 Does this partnership meet ALL THREE of the following requirements? a The partnership’s total receipts for the tax year were less than $250,000; b The partnership’s total assets at the end of the tax year were less than $600,000; AND c Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return. If “Yes,” the partnership is not required to complete Schedules L, M-1, and M-2; Item F on page 1 of Form 1065; or Item J on Schedule K-1 ߛ 6 Does this partnership have any foreign partners? ߛ 7 Is this partnership a publicly traded partnership as defined in section 469(k)(2)? ߛ 8 Has this partnership filed, or is it required to file, Form 8264, Application for Registration of a Tax Shelter? ߛ 9 At any time during calendar year 1997, did the partnership have an interest in or a signature or other authority over a financial account in a foreign country (such as a bank account, securities account, or other financial account)? See page 14 of the instructions for exceptions and filing requirements for Form TD F 90-22.1. If “Yes,” enter the name of the foreign country. ᮣ ߛ 10 During the tax year, did the partnership receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If “Yes,” the partnership may have to file Form 3520 or 926. See page 14 of the instructions ߛ 11 Was there a distribution of property or a transfer (e.g., by sale or death) of a partnership interest during the tax year? If “Yes,” you may elect to adjust the basis of the partnership’s assets under section 754 by attaching the statement described under Elections Made By the Partnership on page 5 of the instructions ߛ Designation of Tax Matters Partner (see page 15 of the instructions) Enter below the general partner designated as the tax matters partner (TMP) for the tax year of this return:

Name of Identifying designated TMP ᮣ number of TMP ᮣ Address of designated TMP ᮣ

Page 22 Form 1065 (1997) Page 3 Schedule K Partners’ Shares of Income, Credits, Deductions, etc. (a) Distributive share items (b) Total amount 1 Ordinary income (loss) from trade or business activities (page 1, line 22) 1 49,370 2 Net income (loss) from rental real estate activities (attach Form 8825) 2 3a Gross income from other rental activities 3a b Expenses from other rental activities (attach schedule) 3b c Net income (loss) from other rental activities. Subtract line 3b from line 3a 3c 4 Portfolio income (loss): a Interest income 4a b Dividend income 4b 150 c Royalty income 4c d Net short-term capital gain (loss) (attach Schedule D (Form 1065)) 4d e Net long-term capital gain (loss) (attach Schedule D (Form 1065)): Income (Loss) (1) 28% rate gain (loss) ᮣ (2) Total for year ᮣ 4e(2) f Other portfolio income (loss) (attach schedule) 4f 5 Guaranteed payments to partners 5 25,000 6 Net section 1231 gain (loss) (other than due to casualty or theft) (attach Form 4797): a 28% rate gain (loss) ᮣ b Total for year ᮣ 6b 7 Other income (loss) (attach schedule) 7 8 Charitable contributions (attach schedule) 8 650 9 Section 179 expense deduction (attach Form 4562) 9 10 Deductions related to portfolio income (itemize) 10 Deduc- tions 11 Other deductions (attach schedule) 11 12a Low-income housing credit: (1) From partnerships to which section 42(j)(5) applies for property placed in service before 1990 12a(1) (2) Other than on line 12a(1) for property placed in service before 1990 12a(2) (3) From partnerships to which section 42(j)(5) applies for property placed in service after 1989 12a(3) (4) Other than on line 12a(3) for property placed in service after 1989 12a(4)

Credits b Qualified rehabilitation expenditures related to rental real estate activities (attach Form 3468) 12b c Credits (other than credits shown on lines 12a and 12b) related to rental real estate activities 12c d Credits related to other rental activities 12d 13 Other credits 13 14a Interest expense on investment debts 14a b (1) Investment income included on lines 4a, 4b, 4c, and 4f above 14b(1) 150

Invest- ment Interest (2) Investment expenses included on line 10 above 14b(2) 15a Net earnings (loss) from self-employment 15a 74,370 b Gross farming or fishing income 15b

Self- Employ- ment c Gross nonfarm income 15c 16a Depreciation adjustment on property placed in service after 1986 16a b Adjusted gain or loss 16b c Depletion (other than oil and gas) 16c

Items d (1) Gross income from oil, gas, and geothermal properties 16d(1) (2) Deductions allocable to oil, gas, and geothermal properties 16d(2) Tax Preference Adjustments and e Other adjustments and tax preference items (attach schedule) 16e 17a Type of income ᮣ b Name of foreign country or U.S. possession ᮣ c Total gross income from sources outside the United States (attach schedule) 17c d Total applicable deductions and losses (attach schedule) 17d e Total foreign taxes (check one): ᮣ Paid Accrued 17e f Reduction in taxes available for credit (attach schedule) 17f Foreign Taxes g Other foreign tax information (attach schedule) 17g 18 Section 59(e)(2) expenditures: a Type ᮣ b Amount ᮣ 18b 19 Tax-exempt interest income 19 50 20 Other tax-exempt income 20 21 Nondeductible expenses 21 Other 22 Distributions of money (cash and marketable securities) 22 52,880 23 Distributions of property other than money 23 24 Other items and amounts required to be reported separately to partners (attach schedule)

Page 23 Form 1065 (1997) Page 4 Analysis of Net Income (Loss) 1 Net income (loss). Combine Schedule K, lines 1 through 7 in column (b). From the result, subtract the sum of Schedule K, lines 8 through 11, 14a, 17e, and 18b 1 73,870 (ii) Individual (iii) Individual (v) Exempt 2 Analysis by (i) Corporate (iv) Partnership (vi) Nominee/Other partner type: (active) (passive) organization a General partners 73,870 b Limited partners Schedule L Balance Sheets per Books (Not required if Question 5 on Schedule B is answered “Yes.”) Beginning of tax year End of tax year Assets (a) (b) (c) (d) 1 Cash 3,455 3,350 2a Trade notes and accounts receivable 7,150 10,990 b Less allowance for bad debts 7,150 10,990 3 Inventories 18,125 19,225 4 U.S. government obligations 5 Tax-exempt securities 1,000 1,000 6 Other current assets (attach schedule) 7 Mortgage and real estate loans 8 Other investments (attach schedule) 1,000 1,000 9a Buildings and other depreciable assets 15,000 15,000 b Less accumulated depreciation 4,000 11,000 5,174 9,826 10a Depletable assets b Less accumulated depletion 11 Land (net of any amortization) 12a Intangible assets (amortizable only) b Less accumulated amortization 13 Other assets (attach schedule) 14 Total assets 41,730 45,391 Liabilities and Capital 15 Accounts payable 10,180 10,462 16 Mortgages, notes, bonds payable in less than 1 year 4,000 3,600 17 Other current liabilities (attach schedule) 18 All nonrecourse loans 19 Mortgages, notes, bonds payable in 1 year or more 7,739 20 Other liabilities (attach schedule) 21 Partners’ capital accounts 27,550 23,590 22 Total liabilities and capital 41,730 45,391 Reconciliation of Income (Loss) per Books With Income (Loss) per Return Schedule M-1 (Not required if Question 5 on Schedule B is answered “Yes.” See page 23 of the instructions.) 1 Net income (loss) per books 48,920 6 Income recorded on books this year not included 2 Income included on Schedule K, lines 1 on Schedule K, lines 1 through 7 (itemize): through 4, 6, and 7, not recorded on books a Tax-exempt interest $ 50 this year (itemize): 50 3 Guaranteed payments (other than health 7 Deductions included on Schedule K, lines 1 insurance) 25,000 through 11, 14a, 17e, and 18b, not charged 4 Expenses recorded on books this year not against book income this year (itemize): included on Schedule K, lines 1 through a Depreciation $ 11, 14a, 17e, and 18b (itemize): a Depreciation $ b Travel and entertainment $ 8 Add lines 6 and 7 50 9 Income (loss) (Analysis of Net Income (Loss), 5 Add lines 1 through 4 73,920 line 1). Subtract line 8 from line 5 73,870 Schedule M-2 Analysis of Partners’ Capital Accounts (Not required if Question 5 on Schedule B is answered “Yes.”) 1 Balance at beginning of year 27,550 6 Distributions: a Cash 52,880 2 Capital contributed during year b Property 3 Net income (loss) per books 48,920 7 Other decreases (itemize): 4 Other increases (itemize): 8 Add lines 6 and 7 52,880 5 Add lines 1 through 4 76,470 9 Balance at end of year. Subtract line 8 from line 5 23,590

Page 24 SCHEDULE K-1 Partner’s Share of Income, Credits, Deductions, etc. OMB No. 1545-0099 (Form 1065) ᮣ See separate instructions. Department of the Treasury Internal Revenue Service For calendar year 1997 or tax year beginning , 1997, and ending , 19 1997 Partner’s identifying number ᮣ 123-00-6789 Partnership’s identifying number ᮣ 10 9876543 Partner’s name, address, and ZIP code Partnership’s name, address, and ZIP code Frank W. Able Able Baker Book Store 10 Green Street 334 West Main Street Orange, MD 20904 Orange, MD 20904

A This partner is a ߛ general partner limited partner F Partner’s share of liabilities (see instructions): limited liability company member Nonrecourse $ B What type of entity is this partner? ᮣ Individual Qualified nonrecourse financing $ C Is this partner a ߛ domestic or a foreign partner? Other $ 10,900 (i) Before change (ii) End of ᮣ D Enter partner’s percentage of: or termination year G Tax shelter registration number N/A Profit sharing % 50 % H Check here if this partnership is a publicly traded Loss sharing % 50 % partnership as defined in section 469(k)(2) Ownership of capital % 50 % E IRS Center where partnership filed return: Philadelphia I Check applicable boxes: (1) Final K-1 (2) Amended K-1 J Analysis of partner’s capital account: (c) Partner’s share of lines (e) Capital account at end of (a) Capital account at (b) Capital contributed (d) Withdrawals and 3, 4, and 7, Form 1065, year (combine columns (a) beginning of year during year distributions Schedule M-2 through (d)) 14,050 24,460 ( 26,440 ) 12,070 (c) 1040 filers enter the (a) Distributive share item (b) Amount amount in column (b) on:

1 Ordinary income (loss) from trade or business activities 1 24,685 See page 6 of Partner’s 2 Net income (loss) from rental real estate activities 2 Instructions for Schedule K-1 (Form 1065). 3 Net income (loss) from other rental activities 3 ͖ 4 Portfolio income (loss): a Interest 4a Sch. B, Part I, line 1 b Dividends 4b 75 Sch. B, Part II, line 5 c Royalties 4c Sch. E, Part I, line 4 d Net short-term capital gain (loss) 4d Sch. D, line 5, col. (f) e Net long-term capital gain (loss): (1) 28% rate gain (loss) e(1) Sch. D, line 12, col. (g) (2) Total for year e(2) Sch. D, line 12, col. (f) Income (Loss) f Other portfolio income (loss) (attach schedule) 4f Enter on applicable line of your return. 5 Guaranteed payments to partner 5 20,000 See page 6 of Partner’s 6 Net section 1231 gain (loss) (other than due to casualty or theft): Instructions for Schedule K-1 a 28% rate gain (loss) 6a (Form 1065). b Total for year 6b ͖ 7 Other income (loss) (attach schedule) 7 Enter on applicable line of your return. 8 Charitable contributions (see instructions) (attach schedule) 8 325 Sch. A, line 15 or 16 9 Section 179 expense deduction 9 See page 7 of Partner’s 10 Instructions for Schedule K-1 tions 10 Deductions related to portfolio income (attach schedule)

Deduc- (Form 1065). 11 Other deductions (attach schedule) 11 ͖ 12a Low-income housing credit: (1) From section 42(j)(5) partnerships for property placed in service before 1990 a(1) (2) Other than on line 12a(1) for property placed in service before 1990 a(2) (3) From section 42(j)(5) partnerships for property placed in Form 8586, line 5 a(3) s service after 1989 t i a(4)

d (4) Other than on line 12a(3) for property placed in service after 1989

e ͖ r b Qualified rehabilitation expenditures related to rental real estate C activities 12b c Credits (other than credits shown on lines 12a and 12b) related See page 8 of Partner’s to rental real estate activities 12c Instructions for Schedule K-1 (Form 1065). d Credits related to other rental activities 12d 13 Other credits 13 ͖ For Paperwork Reduction Act Notice, see Instructions for Form 1065. Cat. No. 11394R Schedule K-1 (Form 1065) 1997

Page 25 Schedule K-1 (Form 1065) 1997 Page 2 (c) 1040 filers enter the (a) Distributive share item (b) Amount amount in column (b) on:

14a Interest expense on investment debts 14a Form 4952, line 1 b(1) See page 8 of Partner’s b (1) Investment income included on lines 4a, 4b, 4c, and 4f 75 Instructions for Schedule K-1 Interest

Investment (2) Investment expenses included on line 10 b(2) ͖ (Form 1065). 15a Net earnings (loss) from self-employment 15a 44,685 Sch. SE, Section A or B 15b See page 9 of Partner’s b Gross farming or fishing income Instructions for Schedule K-1 Self-em- ployment c Gross nonfarm income 15c ͖ (Form 1065). 16a Depreciation adjustment on property placed in service after 1986 16a b Adjusted gain or loss 16b See page 9 of Partner’s 16c Instructions c Depletion (other than oil and gas) for Schedule K-1 d (1) Gross income from oil, gas, and geothermal properties d(1) (Form 1065) and (2) Deductions allocable to oil, gas, and geothermal properties d(2) Instructions for Form 6251. Preference Items

Adjustments and Tax e Other adjustments and tax preference items (attach schedule) 16e ͖ 17a Type of income ᮣ Form 1116, check boxes

s b Name of foreign country or possession ᮣ e x

a c Total gross income from sources outside the United States (attach Form 1116, Part I T schedule) 17c n

g 17d i d Total applicable deductions and losses (attach schedule) ͖ e r e Total foreign taxes (check one): ᮣ Paid Accrued 17e Form 1116, Part II o

F f Reduction in taxes available for credit (attach schedule) 17f Form 1116, Part III g Other foreign tax information (attach schedule) 17g See Instructions for Form 1116. 18 Section 59(e)(2) expenditures: a Type ᮣ See page 9 of Partner’s Instructions for Schedule K-1 b Amount 18b ͖ (Form 1065). 19 Tax-exempt interest income 19 25 Form 1040, line 8b 20 Other tax-exempt income 20 21 See page 9 of Partner’s 21 Nondeductible expenses Instructions for Schedule K-1 22 Distributions of money (cash and marketable securities) 22 26,440 (Form 1065). Other 23 Distributions of property other than money 23 ͖ 24 Recapture of low-income housing credit: 24a a From section 42(j)(5) partnerships Form 8611, line 8 b Other than on line 24a 24b ͖ 25 Supplemental information required to be reported separately to each partner (attach additional schedules if more space is needed): Supplemental Information

Page 26 It also contains an index of tax topics and Evaluating the quality of our telephone related publications and describes other free services. To ensure that IRS representatives How To Get More tax services available from the IRS, including give accurate, courteous, and professional tax education and assistance programs. answers, we evaluate the quality of our “800 Information If you have access to a personal computer number” telephone services in several ways. and modem, you can also get many forms and publications electronically. See Quick 1) A second IRS representative sometimes monitors live telephone calls. That per- and Easy Access to Tax Help and Forms in your income tax package for details. son only evaluates the IRS assistor and You can get help from the IRS in several does not keep a record of any taxpayer's ways. name or tax identification number. Tax questions. You can call the IRS with Free publications and forms. To order free your tax questions. Check your income tax 2) We sometimes record telephone calls to publications and forms, call 1–800–TAX– package or telephone book for the local evaluate IRS assistors objectively. We FORM (1–800–829–3676). You can also number, or you can call 1–800–829–1040. hold these recordings no longer than one write to the IRS Forms Distribution Center week and use them only to measure the nearest you. Check your income tax package TTY/TDD equipment. If you have access to quality of assistance. for the address. Your local library or post of- TTY/TDD equipment, you can call 1–800– 3) We value our customers' opinions. fice may also have the items you need. 829–4059 to ask tax questions or to order Throughout this year, we will be survey- For a list of free tax publications, order forms and publications. See your income tax ing our customers for their opinions on Publication 910, Guide to Free Tax Services. package for details. our service.

Index

Determined by interest in part- Constructive ...... 14 Interest ...... 6 A nership ...... 6 Partner's interest ...... 9 Liabilities ...... 14 Activity not for profit ...... 7 Guaranteed payments ...... 11 Partner's retirement or death 15 Terminating ...... 3 Allocations: Limits on losses ...... 7 Losses: Transactions with partner ..... 11 Built-in gain or loss ...... 12 Partner's ...... 6 Limits ...... 7 Passive activities ...... 7 Installment sale ...... 15 Reporting ...... 6 Sales or exchanges ...... 12 Penalties: Interest expense ...... 8 Self-employment tax ...... 6 Criminal ...... 5 Nonrecourse liability ...... 6 Year of disposition ...... 17 Failure to file ...... 5 Partnership items ...... 19 Failure to furnish copy of Substantial economic effect ... 6 M Marketable securities ...... 9 Schedule K–1 ...... 5 Alternative minimum tax ...... 6 E Other ...... 5 At-risk limits ...... 7 Trust fund recovery ...... 5 Estimated tax ...... 6 Audit, consolidated ...... 7 Precontribution gain ...... 9 Expenses paid by partner ...... 8 N Principal partner defined ...... 4 Nonrecourse liability ...... 6 Problem Resolution Program ...... 2 B Not-for-profit activity ...... 7 Profits interest ...... 13 F Publications and forms, free ..... 27 Basis, partnership: Family partnership ...... 3 Adjusting ...... 18 Form 1065: Distributions ...... 18 O Due date ...... 5 Organization expenses ...... 6 R Election, optional adjustment 18 Example ...... 18 Related person ...... 14 Transfer of interest ...... 18 Schedule K–1 ...... 5, 19 Retiring partner ...... 15 Built-in gain or loss ...... 12 Form: 982 ...... 7 P 8082 ...... 7 Partner's: C 8308 ...... 16 Alternative minimum tax ...... 6 S Capital interest ...... 3, 13 8832 ...... 2 Basis, distributed property ..... 9 Section 179 deduction ...... 8 Contribution: Basis, partnership interest ... 13 Self-employed health insurance 11 Basis of property ...... 12 Distributive share ...... 6 Self-employment tax ...... 6 Built-in gain or loss ...... 12 G Estimated tax ...... 6 Short period return ...... 3, 4 Distribution of property ...... 13 Interest: Substantial economic effect ...... 6 Gross income, partner ...... 6 Acquired by gift ...... 13 Substantially appreciated inven- Net precontribution gain ...... 9 Guaranteed payments ...... 11 Property ...... 12 Alternative rule, adjusted tory items ...... 16 Services ...... 13 basis ...... 14 Syndication fees ...... 6 Basis ...... 13 H Basis adjustments ...... 13 Help from IRS ...... 27 Book value ...... 14 T D Husband-wife partnership ...... 3 Liquidation of ...... 9, 15 Tax withholding, foreign person or Deceased partner: Mandatory basis adjust- firm ...... 1 Distributive share ...... 17 ment ...... 11 Tax year: Liquidation of interest ...... 15 Sale, exchange, transfer . 15 Business purpose ...... 4 Self-employment income ...... 17 I Special basis adjustment 10 Insurance, self-employed health 11 Exceptions ...... 4 Definition, partnership ...... 2 Transactions with partnership 11 Inventory items, substantially ap- Partner ...... 4 Determining ownership ...... 12 Partnership: preciated ...... 16 Partnership ...... 4 Distributions: Abandoned or worthless inter- Required ...... 4 Gain or loss ...... 9 est ...... 15 Section 444 election ...... 4 Interest expense, loan ...... 8 Agreement ...... 3 Short period return ...... 4 Partner's debt ...... 9 L Basis, contributed property .. 12 Terminating a partnership ...... 3 Partnership ...... 8 Liability: Capital interest ...... 3 Distributive share: Assumption of ...... 14 Defined ...... 2 Adjusted basis ...... 13 Nonrecourse ...... 6 Exclusion from rules ...... 3 Canceled qualified real property Partner's assumed by partner- Family ...... 3 U business debt ...... 7 ship ...... 13 Forming ...... 2 Unrealized receivables ...... 16 Character of items ...... 7 Partnership's ...... 14 Husband-wife ...... 3 Ⅵ Deceased partner ...... 17 Liquidation: Income or loss ...... 5

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